SFM (New) ICAI SM For May 2021

Final Course
(Revised Scheme of Education and Training)
Study Material
PAPER 2
Strategic Financial
Management
BOARD OF STUDIES
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA
Compiled by @group1_notes
© The Institute of Chartered Accountants of India
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This study material has been prepared by the faculty of the Board of Studies. The objective of the
study material is to provide teaching material to the students to enable them to obtain knowledge
in the subject. In case students need any clarifications or have any suggestions for further
improvement of the material contained herein, they may write to the Director of Studies.
All care has been taken to provide interpretations and discussions in a manner useful for the
students. However, the study material has not been specifically discussed by the Council of the
Institute or any of its Committees and the views expressed herein may not be taken to necessarily
represent the views of the Council or any of its Committees.
Permission of the Institute is essential for reproduction of any portion of this material.
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otherwise, without prior permission, in writing, from the publisher.
Edition : November, 2020
Website : www.icai.org
E-mail : bosnoida@icai.in
Committee/ : Board of Studies

Department
ISBN No. :
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Published by : The Publication Department on behalf of The Institute of Chartered

Accountants of India, ICAI Bhawan, Post Box No. 7100,
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BEFORE WE BEGIN…
The ICAI had recently revised its course curriculum. The topics, wherever required have been
updated keeping in view the modern requirements of Finance. Strategic Financial Management
(SFM) is one of the core papers for students appearing in Final Level of Chartered Accountancy
Course.
As you all are aware that SFM is a blend of Strategic Management and Financial Management.
Recently, it has gained significance due to growing globalization and continuous cross border flow
of capital.
Although corrections have been carried in almost all Chapters of the Study Material of this edition
vis-à-vis the previous edition of August 2019, however, a thorough revision has been carried out in
the following chapters:
(i) Chapter 4 – Security Valuation
(ii) Chapter 5 – Portfolio Management
(iii) Chapter 12 – Corporate Valuation
In addition to the above, in this Edition, number of Numerical Questions for practice
purpose have been almost doubled.
Further, there are several significant characteristics of this study material which are outlined as below:
(i) It comprehensively covers the course requirements of students preparing for SFM paper.
(ii) It is written in a very simple and lucid manner to make the subject understandable to the
students.
(iii) At the beginning of each chapter, learning outcomes have been given so that the students
know in advance as to what he will learn after going through the chapter.
(iv) At the end of each chapter, under the caption, “Test your Knowledge” is given. Basically,
the purpose of the same is to motivate the students to recapitulate what they have learnt in
the chapter.
(v) While preparing the study material, every effort has been made to keep the chapters
concise, giving appropriate headings, sub-headings and examples, at suitable places.
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We are confident that this study material will prove to be extremely useful to the students.
Although, sincere efforts have been made to keep the study material error free, it is possible that
some error might have inadvertently crept in. In this respect, students are encouraged to highlight
any mistake they may notice while going through the study material by sending an e-mail at: sfm-
final@icai.in or write to the Director of Studies, The Institute of Chartered Accountants of India, A-
29, Sector-62, Noida-201309.
Happy Reading and Best Wishes!
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SYLLABUS
PAPER 2: STRATEGIC FINANCIAL MANAGEMENT

(One paper – Three hours – 100 marks)
Objective:
To acquire the ability to apply financial management theories and techniques in strategic decision making.
Contents:
(1) Financial Policy and Corporate Strategy
(i) Strategic decision making framework
(ii) Interface of Financial Policy and strategic management
(iii) Balancing financial goals vis-à-vis sustainable growth.
(2) Risk Management
(i) Identification of types of Risk faced by an organisation
(ii) Evaluation of Financial Risks
(iii) Value at Risk (VAR)
(iv) Evaluation of appropriate method for the identification and management of financial risk.
(3) Security Analysis
(i) Fundamental Analysis
(ii) Technical Analysis
a) Meaning
b) Assumptions
c) Theories and Principles
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d) Charting Techniques
e) Efficient Market Hypothesis (EMH) Analysis
(4) Security Valuation
(i) Theory of Valuation
(ii) Return Concepts
(iii) Equity Risk Premium
(iv) Required Return on Equity
(v) Discount Rate Selection in Relation to Cash Flows
(vi) Approaches to Valuation of Equity Shares
(vii) Valuation of Preference Shares
(viii) Valuation of Debentures/ Bonds
(5) Portfolio Management
(i) Portfolio Analysis
(ii) Portfolio Selection
(iii) Capital Market Theory
(iv) Portfolio Revision
(v) Portfolio Evaluation
(vi) Asset Allocation
(vii) Fixed Income Portfolio
(viii) Risk Analysis of Investment in Distressed Securities
(ix) Alternative Investment Strategies in context of Portfolio Management
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(6) Securitization
(i) Introduction
(ii) Concept and Definition
(iii) Benefits of Securitization
(iv) Participants in Securitization
(v) Mechanism of Securitization
(vi) Problems in Securitization
(vii) Securitization Instruments
(viii) Pricing of Securitization Instruments
(ix) Securitization in India
(7) Mutual Fund
(i) Meaning
(ii) Evolution
(iii) Types
(iv) Advantages and Disadvantages of Mutual Funds
(8) Derivatives Analysis and Valuation
(i) Forward/ Future Contract
(ii) Options
(iii) Swaps
(iv) Commodity Derivatives
(9) Foreign Exchange Exposure and Risk Management
(i) Exchange rate determination
viii
(ii) Foreign currency market
(iii) Management of transaction, translation and economic exposures
(iv) Hedging currency risk
(v) Foreign exchange derivatives – Forward, futures, options and swaps
(10) International Financial Management
(i) International Capital Budgeting
(ii) International Working Capital Management
a) Multinational Cash Management
- Objectives of Effective Cash Management
- Optimization of Cash Flows/ Needs
- Investment of Surplus Cash
b) Multinational Receivable Management
c) Multinational Inventory Management
(11) Interest Rate Risk Management
(i) Interest Rate Risk
(ii) Hedging Interest Rate Risk
a) Traditional Methods
b) Modern Methods including Interest Rate Derivatives
(12) Corporate Valuation
(i) Conceptual Framework of Valuation
(ii) Approaches/ Methods of Valuation
a) Assets Based Valuation Model
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b) Earning Based Models
c) Cash Flow Based Models
d) Measuring Cost of Equity
- Capital Asset Pricing Model (CAPM)
- Arbitrage Pricing Theory
- Estimating Beta of an unlisted company
e) Relative Valuation
- Steps involved in Relative Valuation
- Equity Valuation Multiples
- Enterprise Valuation Multiple
f) Other Approaches to Value Measurement
- Economic Value Added (EVA)
- Market Value Added (MVA)
- Shareholder Value Analysis (SVA)
g) Arriving at Fair Value
(13) Mergers, Acquisitions and Corporate Restructuring
(i) Conceptual Framework
(ii) Rationale
(iii) Forms
(iv) Mergers and Acquisitions
a) Financial Framework
b) Takeover Defensive Tactics
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c) Reverse Merger
(v) Divestitures
a) Partial Sell off
b) Demerger
c) Equity Carve outs
(vi) Ownership Restructuring
a) Going Private
b) Management/ Leveraged Buyouts
(vii) Cross Border Mergers
(14) Startup Finance
(i) Introduction including Pitch Presentation
(ii) Sources of Funding
(iii) Startup India Initiative
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CONTENTS
CHAPTER 1 – FINANCIAL POLICY AND CORPORATE STRATEGY
1. Strategic Financial Decision Making Frame Work ......................................................... 1.1
2. Strategy at Different Hierarchy Levels .......................................................................... 1.3
3. Financial Planning ....................................................................................................... 1.4
4. Interface of Financial Policy and Strategic Management ............................................... 1.5
5. Balancing Financial Goals vis-à-vis Sustainable Growth ............................................... 1.7
CHAPTER 2 – RISK MANAGEMENT
1. Identification of types of Risk faced by an organization ................................................. 2.1
2. Evaluation of Financial Risk ........................................................................................ 2.4
3. Value-at-Risk (VAR) ..................................................................................................... 2.4
4. Appropriate Methods for Identification and Management of Financial Risk ..................... 2.5
CHAPTER 3 – SECURITY ANALYSIS
1. Fundamental Analysis .................................................................................................. 3.2
2. Technical Analysis ..................................................................................................... 3.14
3. Difference between Fundamental Analysis and Technical Analysis .............................. 3.29
4. Efficient Market Theory .............................................................................................. 3.30
CHAPTER 4 – SECURITY VALUATION
1. Overview of Valuation .................................................................................................. 4.1
2. Return Concepts .......................................................................................................... 4.2
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3. Equity Risk Premium .................................................................................................... 4.4
4. Required Return on Equity ........................................................................................... 4.5
5. Discounts rates selection in relation to cash flows ........................................................ 4.5
6. Valuation of Equity Shares ........................................................................................... 4.6
7. Valuation of Preference Shares .................................................................................. 4.14
8. Valuation of Debentures and Bonds ........................................................................... 4.15
CHAPTER 5 – PORTFOLIO MANAGEMENT
1. Introduction ................................................................................................................. 5.2
2. Phases of Portfolio Management .................................................................................. 5.4
3. Portfolio Theories ........................................................................................................ 5.7
4. Risk Analysis ............................................................................................................... 5.9
5. Markowitz Model of Risk-Return Optimization ............................................................. 5.28
6. Capital Market Theory ................................................................................................ 5.31
7. Single Index Model .................................................................................................... 5.32
8. Capital Asset Pricing Model ....................................................................................... 5.36
9. Arbitrage Pricing Theory Model .................................................................................. 5.44
10. Portfolio Evaluation Methods ...................................................................................... 5.46
11. Sharpe’s Optimal Portfolio.......................................................................................... 5.49
12. Formulation of Portfolio Strategy ................................................................................ 5.50
13. Portfolio Revision and Rebalancing ............................................................................ 5.53
14. Asset Allocation Strategies ......................................................................................... 5.57
15. Fixed Income Portfolio ............................................................................................... 5.57
16. Alternative Investment Strategies in context of Portfolio Management ......................... 5.60
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CHAPTER 6 – SECURITIZATION
1. Introduction ................................................................................................................. 6.1
2. Concept and Definition ................................................................................................. 6.2
3. Benefits of Securitization.............................................................................................. 6.2
4. Participants in Securitization ........................................................................................ 6.3
5. Mechanism of Securitization ......................................................................................... 6.5
6. Problems in Securitization ............................................................................................ 6.6
7. Securitization Instruments ............................................................................................ 6.7
8. Pricing of the Securitized Instruments .......................................................................... 6.8
9. Securitization in India ................................................................................................... 6.9
CHAPTER 7 – MUTUAL FUNDS
1. Introduction ................................................................................................................. 7.1
2. Evolution of the Indian Mutual Fund Industry ................................................................ 7.3
3. Classification of Mutual Funds ...................................................................................... 7.5
4. Types of Schemes ....................................................................................................... 7.9
5. Advantages of Mutual Fund ........................................................................................ 7.13
6. Drawbacks of Mutual Fund ......................................................................................... 7.14
7. Terms associated with Mutual Funds .......................................................................... 7.15
CHAPTER 8 – DERIVATIVES ANALYSIS AND VALUATION
1. Introduction ................................................................................................................. 8.1
2. Forward Contract ......................................................................................................... 8.2
3. Future Contract ............................................................................................................ 8.3
4. Pricing / Valuation of Forward / Future Contracts .......................................................... 8.5
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5. Types of Futures Contracts .......................................................................................... 8.8
6. Options ...................................................................................................................... 8.17
7. Option Valuation Techniques ..................................................................................... 8.21
8. Commodity Derivatives .............................................................................................. 8.32
9. Embedded Derivatives ............................................................................................... 8.39
CHAPTER 9 – FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
1. Introduction ................................................................................................................. 9.1
2. Nostro, Vostro and Loro Accounts ................................................................................ 9.2
3. Exchange Rate Quotation ............................................................................................ 9.4
4. Exchange Rate Forecasting ....................................................................................... 9.10
5. Exchange Rate Determination .................................................................................... 9.11
6. Exchange Rate Theories ............................................................................................ 9.12
7. Foreign Exchange Market .......................................................................................... 9.17
8. Foreign Exchange Exposure ...................................................................................... 9.18
9. Hedging Currency Risk .............................................................................................. 9.21
10. Forward Contract ....................................................................................................... 9.25
11. Future Contracts ........................................................................................................ 9.36
12. Option Contracts ........................................................................................................ 9.37
13. Swap Contracts ......................................................................................................... 9.39
14. Strategies for Exposure Management ......................................................................... 9.40
15. Conclusion ................................................................................................................ 9.42
CHAPTER 10 – INTERNATIONAL FINANCIAL MANAGEMENT
1. International Capital Budgeting ..................................................... ……………………..10.1
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2. International Sources of Finance .................................................................. ………..10.15
3. International Working Capital Management............................................................... 10.20
CHAPTER 11 – INTEREST RATE RISK MANAGEMENT
1. Introduction ............................................................................................................... 11.1
2. Hedging Interest Rate Risk ........................................................................................ 11.5
CHAPTER 12 – CORPORATE VALUATION
1. Conceptual Framework of Valuation ........................................................................... 12.2
2. Important terms associated with Valuation .................................................................. 12.3
3. Approaches/ Methods of Valuation ............................................................................. 12.4
4. Measuring Cost of Equity ......................................................................................... 12.10
5. Relative Valuation .................................................................................................... 12.14
6. Other Approaches to Value Measurement ................................................................ 12.18
7. Arriving at Fair Value ............................................................................................... 12.26
CHAPTER 13 – MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING
1. Conceptual Framework .............................................................................................. 13.2
2. Rationale for Mergers and Acquisition ........................................................................ 13.4
3. Forms (Types) of Mergers .......................................................................................... 13.6
4. Financial Framework .................................................................................................. 13.8
5. Takeover Defensive Tactics ..................................................................................... 13.11
6. Reverse Merger ....................................................................................................... 13.13
7. Divestiture ............................................................................................................... 13.13
8. Financial Restructuring ............................................................................................ 13.16
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9. Ownership Restructuring .......................................................................................... 13.20
10. Premium and Discount ............................................................................................. 13.22
11. Case Studies ........................................................................................................... 13.23
12. Mergers and Acquisitions Failures ............................................................................ 13.31
13. Acquisition through Shares ...................................................................................... 13.32
14. Cross-Border M&A ................................................................................................... 13.37
CHAPTER 14 – STARTUP FINANCE
1. The Basics of Startup Financing ................................................................................. 14.1
2. Some of the Innovative Ways to Finance a Startup ..................................................... 14.2
3. Pitch Presentation ...................................................................................................... 14.3
4. Modes of Financing for Startups ................................................................................. 14.6
5. Startup India Initiative .............................................................................................. 14.14
1
FINANCIAL POLICY AND

CORPORATE STRATEGY
LEARNING OUTCOMES
After reading this chapter student shall be able to understand:
❑ Strategic Financial Decision Making Framework
❑ Strategy at Different Hierarchy Levels
❑ Financial Planning
❑ Interface of Financial Policy and Strategic Management
❑ Balancing Financial Goals vis-à-vis Sustainable Growth
1. STRATEGIC FINANCIAL DECISION MAKING

FRAMEWORK
Capital investment is the springboard for wealth creation. In a world of economic uncertainty, the
investors want to maximize their wealth by selecting optimum investment and financial
opportunities that will give them maximum expected returns at minimum risk. Since management is
ultimately responsible to the investors, the objective of corporate financial management s hould
implement investment and financing decisions which should satisfy the shareholders by placing
them all in an equal, optimum financial position. The satisfaction of the interests of the
shareholders should be perceived as a means to an end, namely max imization of shareholders’
wealth. Since capital is the limiting factor, the problem that the management will face is the
1.2 STRATEGIC FINANCIAL MANAGEMENT
strategic allocation of limited funds between alternative uses in such a manner, that the companies
have the ability to sustain or increase investor returns through a continual search for investment
opportunities that generate funds for their business and are more favourable for the investors.
Therefore, all businesses need to have the following three fundamental essential elements:
• A clear and realistic strategy,
• The financial resources, controls and systems to see it through and
• The right management team and processes to make it happen.
We may summarise this by saying that:
Strategy + Finance + Management = Fundamentals of Business

Strategy may be defined as the long-term direction and scope of an organization to achieve
competitive advantage through the configuration of resources within a changing environment for
the fulfilment of stakeholder’s aspirations and expectations. In an idealized world, management is
ultimately responsible to the investors. Investors maximize their wealth by selecting optimum
investment and financing opportunities, using financial models that maximize expected returns in
absolute terms at minimum risk. What concerns the investors is not simply maximum profit but also
the likelihood of it arising: a risk-return trade-off from a portfolio of investments, with which they
feel comfortable and which may be unique for each individual.
We call this overall approach strategic financial management and define it as being the application
to strategic decisions of financial techniques in order to help achieve the decision -maker's
objectives. Although linked with accounting, the focus of strategic financial management is
different. Strategic financial management combines the backward-looking, report-focused
discipline of (financial) accounting with the more dynamic, forward-looking subject of financial
management. It is basically about the identification of the possible strategies capable of
maximizing an organization's market value. It involves the allocation of scarce capital resources
among competing opportunities. It also encompasses the implementation and monitoring of the
chosen strategy so as to achieve agreed objectives.
1.1 Functions of Strategic Financial Management

Strategic Financial Management is the portfolio constituent of the corporate strategic plan that
embraces the optimum investment and financing decisions required to attain the overall specified
objectives. In this connection, it is necessary to distinguish between strategic, tactical and
operational financial planning. While strategy is a long-term course of action, tactics are
intermediate plan, while operations are short-term functions. Senior management decides strategy,
middle level decides tactics and operational are looked after line management.
FINANCIAL POLICY AND CORPORATE STRATEGY 1.3
Irrespective of the time horizon, the investment and financial decisions involve the following
functions 1:
• Continual search for best investment opportunities;
• Selection of the best profitable opportunities;
• Determination of optimal mix of funds for the opportunities;
• Establishment of systems for internal controls; and
• Analysis of results for future decision-making.
Since capital is the limiting factor, the strategic problem for financial management is how limited
funds are allocated between alternative uses.
The key decisions falling within the scope of financial strategy are as follows:
1. Financing decisions: These decisions deal with the mode of financing or mix of equity
capital and debt capital.
2. Investment decisions: These decisions involve the profitable utilization of firm's funds
especially in long-term projects (capital projects). Since the future benefits associated with such
projects are not known with certainty, investment decisions necessarily involve risk. The projects
are therefore evaluated in relation to their expected return and risk.
3. Dividend decisions: These decisions determine the division of earnings between payments
to shareholders and reinvestment in the company.
4. Portfolio decisions: These decisions involve evaluation of investments based on their
contribution to the aggregate performance of the entire corporation rather than on the isolated
characteristics of the investments themselves.
You have already, learnt about the Financing, Investment and Dividend decisions in your
Intermediate (IPC) curriculum, while Portfolio decisions would be taken in detail later in this Study
Material.
2. STRATEGY AT DIFFERENT HIERARCHY LEVELS

Strategies at different levels are the outcomes of different planning needs. There are three levels
of Strategy – Corporate level; Business unit level; and Functional or departmental level.
2.1 Corporate Level Strategy

Corporate level strategy fundamentally is concerned with selection of businesses in which a
company should compete and with the development and coordination of that portfolio of
businesses.
1 Strategic Financial Management: Exercises, Robert Alan Hill.
Corporate level strategy should be able to answer three basic questions:

Suitability Whether the strategy would work for the accomplishment of common
objective of the company.
Feasibility Determines the kind and number of resources required to formulate and
implement the strategy.
Acceptability It is concerned with the stakeholders’ satisfaction and can be financial
and non-financial.
2.2 Business Unit Level Strategy

Strategic business unit (SBO) may be any profit centre that can be planned independently from the
other business units of a corporation. At the business unit level, the strategic issues are about
practical coordination of operating units and developing and sustaining a competitive advantage
for the products and services that are produced.
2.3 Functional Level Strategy

The functional level is the level of the operating divisions and departments. The strategic issues at
this level are related to functional business processes and value chain. Functional level strategies in
R&D, operations, manufacturing, marketing, finance, and human resources involve the development
and coordination of resources through which business unit level strategies can be executed
effectively and efficiently. Functional units of an organization are involved in higher level strategies by
providing input to the business unit level and corporate level strategy, such as providing information
on customer feedback or on resources and capabilities on which the higher level strategies can be
based. Once the higher-level strategy is developed, the functional units translate them into discrete
action plans that each department or division must accomplish for the strategy to succeed .
Among the different functional activities viz production, marketing, finance, human resources and
research and development, finance assumes highest importance during the top down and bottom
up interaction of planning. Corporate strategy deals with deployment of resources and financial
strategy is mainly concerned with mobilization and effective utilization of mo ney, the most critical
resource that a business firm likes to have under its command. Truly speaking, other resources
can be easily mobilized if the firm has adequate monetary base. To go into the details of this
interface between financial strategy and corporate strategy and financial planning and corporate
planning let us examine the basic issues addressed under financial planning.
3. FINANCIAL PLANNING
Financial planning is the backbone of the business planning and corporate planning. It helps in defining
the feasible area of operation for all types of activities and thereby defines the overall planning framework.
Financial planning is a systematic approach whereby the financial planner helps the customer to maximize
his existing financial resources by utilizing financial tools to achieve his financial goals.
There are 3 major components of Financial planning:

• Financial Resources (FR)
• Financial Tools (FT)
• Financial Goals (FG)
Financial Planning = FR + FT + FG
For an individual, financial planning is the process of meeting one’s life goals through proper
management of the finances. These goals may include buying a house, saving for children's
education or planning for retirement. It is a process that consists of specific steps that help s in
taking a big-picture look at where you financially are. Using these steps, you can work out where
you are now, what you may need in the future and what you must do to reach your goals.
Outcomes of the financial planning are the financial objectives, financial deci sion-making and
financial measures for the evaluation of the corporate performance. Financial objectives ar e to be
decided at the very outset so that rest of the decisions can be taken accordingly. The objectives
need to be consistent with the corporate mission and corporate objectives. Financial decision
making helps in analyzing the financial problems that are being faced by the corporate and
accordingly deciding the course of action to be taken by it. The financial measures like ratio
analysis, analysis of cash flow statement are used to evaluate the performance of the Company.
The selection of these measures again depends upon the Corporate objectives.
4. INTERFACE OF FINANCIAL POLICY AND STRATEGIC

MANAGEMENT
The interface of strategic management and financial policy will be clearly understood if we
appreciate the fact that the starting point of an organization is money and the end point of that
organization is also money. No organization can run an existing business and promote a new
expansion project without a suitable internally mobilized financial base or both i.e. internally and
externally mobilized financial base.
Sources of finance and capital structure are the most important dimensions of a strategic plan. The
need for fund mobilization to support the expansion activity of firm is very vital for any
organization. The generation of funds may arise out of ownership capital and or borrowed capital.
A company may issue equity shares and/or preference shares for mobilizing ownership capital and
debentures to raise borrowed capital. Public deposits, for a fixed time period, have also become a
major source of short and medium-term finance. Organizations may offer higher rates of interest
than banking institutions to attract investors and raise fund. The overdraft, cash credits, bill
discounting, bank loan and trade credit are the other sources of short-term finance.
Along with the mobilization of funds, policy makers should decide on the capital structure to
indicate the desired mix of equity capital and debt capital. There are some norms for debt equity
ratio which need to be followed for minimizing the risks of excessive loans. For instance, in case of
public sector organizations, the norm is 1:1 ratio and for private sector firms, the norm is 2:1 ratio.
However, this ratio in its ideal form varies from industry to industry. It also depends on the
planning mode of the organization. For capital intensive industries, the proportion of debt to equity
is much higher. Similar is the case for high cost projects in priority sectors and for projects in
underdeveloped regions.
Another important dimension of strategic management and financial policy interface is the
investment and fund allocation decisions. A planner has to frame policies for regulating
investments in fixed assets and for restraining of current assets. Investment proposals mooted by
different business units may be divided into three groups. One type of proposal will be for addition
of a new product by the firm. Another type of proposal will be to increase the level of operation of
an existing product through either an increase in capacity in the existing plant or setting up of
another plant for meeting additional capacity requirement. The last is for cost reduction and
efficient utilization of resources through a new approach and/or closer monitoring of the different
critical activities. Now, given these three types of proposals a planner should evaluate each one of
them by making within group comparison in the light of capital budgeting exercise. In fact, project
evaluation and project selection are the two most important jobs under fund allocation. Planner’s
task is to make the best possible allocation under resource constraints.
Dividend policy is yet another area for making financial policy decisions affecting the strategic
performance of the company. A close interface is needed to frame the policy to be beneficial for
all. Dividend policy decision deals with the extent of earnings to be distributed as dividend and the
extent of earnings to be retained for future expansion scheme of the firm. From the point of view of
long-term funding of business growth, dividend can be considered as that part of total earnings,
which cannot be profitably utilized by the company. Stability of the dividend payment is a desirable
consideration that can have a positive impact on share prices. The alternative policy of paying a
constant percentage of the net earnings may be preferable from the point of view of both flexibility
of the firm and ability of the firm. It also gives a message of lesser risk for the investors. Yet some
other companies follow a different alternative. They pay a minimum dividend per share and
additional dividend when earnings are higher than the normal earnings. In actual practice,
investment opportunities and financial needs of the firm and the shareholders preference for
dividend against capital gains resulting out of share are to be taken into consideration for arriving
at the right dividend policy. Alternatives like cash dividend and stock di vidend are also to be
examined while working out an ideal dividend policy that supports and promotes the corporate
strategy of the company.
Thus, the financial policy of a company cannot be worked out in isolation of other functional
policies. It has a wider appeal and closer link with the overall organizational performance and
direction of growth. These policies being related to external awareness about the firm, especially
the awareness of the investors about the firm, in respect of its internal performan ce. There is
always a process of evaluation active in the minds of the current and future stake holders of the
company. As a result preference and patronage for the company depends significantly on the
financial policy framework. Hence, attention of the corporate planners must be drawn while framing
the financial policies not at a later stage but during the stage of corporate planning itself. The
nature of interdependence is the crucial factor to be studied and modelled by using an in-depth
analytical approach. This is a very difficult task compared to usual cause and effect study because
corporate strategy is the cause and financial policy is the effect and sometimes financial policy is
the cause and corporate strategy is the effect.
5. BALANCING FINANCIAL GOALS VIS-A-VIS

SUSTAINABLE GROWTH
The concept of sustainable growth can be helpful for planning healthy corporate growth. This
concept forces managers to consider the financial consequences of sales increases and to set
sales growth goals that are consistent with the operating and financial policies of the firm. Often, a
conflict can arise if growth objectives are not consistent with the value of the organization's
sustainable growth. Question concerning right distribution of resources may take a difficult shape if
we take into consideration the rightness not for the current stakeholders but for the future
stakeholders also. To take an illustration, let us refer to fuel industry where resources are limited in
quantity and a judicial use of resources is needed to cater to the need of the future customers
along with the need of the present customers. One may have noticed the save fuel campaign, a
demarketing campaign that deviates from the usual approach of sales growth strategy and
preaches for conservation of fuel for their use across generation. This is an example of stable
growth strategy adopted by the oil industry as a whole under resource constraints and the long run
objective of survival over years. Incremental growth strategy, profit strategy and pa use strategy
are other variants of stable growth strategy.
Sustainable growth is important to enterprise long-term development. Too fast or too slow growth
will go against enterprise growth and development, so financial should play important role in
enterprise development, adopt suitable financial policy initiative to make sure enterprise growth
speed close to sustainable growth ratio and have sustainable healthy development.
What makes an organisation financially sustainable?

To be financially sustainable, an organisation must:
➢ have more than one source of income;
➢ have more than one way of generating income;
➢ do strategic, action and financial planning regularly;
➢ have adequate financial systems;
➢ have a good public image;
➢ be clear about its values (value clarity); and
➢ have financial autonomy.
Source: CIVICUS “Developing a Financing Strategy”.
The sustainable growth rate (SGR), concept by Robert C. Higgins, of a firm is the maximum rate of
growth in sales that can be achieved, given the firm's profitability, asset utilization, and desired
dividend payout and debt (financial leverage) ratios. The sustainable growth rate is a measure of
how much a firm can grow without borrowing more money. After the firm has passed this rate, it
must borrow funds from another source to facilitate growth. Variables typically include the net
profit margin on new and existing revenues; the asset turnover ratio, which is the ratio of sales
revenues to total assets; the assets to beginning of period equity ratio; and the retention rate,
which is defined as the fraction of earnings retained in the business.
SGR = ROE x (1- Dividend payment ratio)

Sustainable growth models assume that the business wants to: 1) maintain a target capital
structure without issuing new equity; 2) maintain a target dividend payment ratio; and 3) increase
sales as rapidly as market conditions allow. Since the asset to beginning of period equity ratio is
constant and the firm's only source of new equity is retained earnings, sales and assets cannot
grow any faster than the retained earnings plus the additional debt that the retained earnings can
support. The sustainable growth rate is consistent with the observed evidence tha t most
corporations are reluctant to issue new equity. If, however, the firm is willing to issue additional
equity, there is in principle no financial constraint on its growth rate. Indeed, the sustainable
growth rate formula is directly predicted on return on equity.
Economists and business researchers contend that achieving sustainable growth is not possible
without paying heed to twin cornerstones: growth strategy and growth capability. Companies that
pay inadequate attention to one aspect or the other are doomed to fail in their efforts to establish
practices of sustainable growth (though short-term gains may be realized). After all, if a company
has an excellent growth strategy in place but has not put the necessary infrastructure in place to
execute that strategy, long-term growth is impossible. The reverse is also true.
The very weak idea of sustainability requires that the overall stock of capital assets should remain
constant. The weak version of sustainability refers to preservation of critical resources to ensure
support for all, over a long-time horizon. The strong concept of sustainability is concerned with the
preservation of resources under the primacy of ecosystem functioning. These are in line with the
definition provided by the economists in the context of sustainable development at macro level.
What makes an organisation sustainable?
➢ In order to be sustainable, an organisation must:
➢ have a clear strategic direction;
➢ be able to scan its environment or context to identify opportunities for its work;
➢ be able to attract, manage and retain competent staff;
➢ have an adequate administrative and financial infrastructure;
➢ be able to demonstrate its effectiveness and impact in order to leverage further
resources; and
➢ get community support for, and involvement in its work.
Source: CIVICUS “Developing a Financing Strategy”.
The sustainable growth model is particularly helpful in situations in which a borrower requests
additional financing. The need for additional loans creates a potentially risky sit uation of too much
debt and too little equity. Either additional equity must be raised, or the borrower will have to
reduce the rate of expansion to a level that can be sustained without an increase in financial
leverage.
Mature firms often have actual growth rates that are less than the sustainable growth rate. In these
cases, management's principal objective is finding productive uses for the cash flows that exist in
excess of their needs. Options available to business owners and executives in such cases
includes returning the money to shareholders through increased dividends or common stock
repurchases, reducing the firm's debt load, or increasing possession of lower earning liquid assets.
These actions serve to decrease the sustainable growth rate. Alternatively, these firms can attempt
to enhance their actual growth rates through the acquisition of rapidly growing companies.
Growth can come from two sources: increased volume and inflation. The inflationary increase in
assets must be financed as though it were real growth. Inflation increases the amount of external
financing required and increases the debt-to-equity ratio when this ratio is measured on a historical
cost basis. Thus, if creditors require that a firm's historical cost debt -to-equity ratio stay constant,
inflation lowers the firm's sustainable growth rate.
Mitsubishi Corporation (MC): New Strategic Direction (charting a new path toward
sustainable growth)
Mitsubishi Corporation has abolished its traditional "midterm management plan" concept of committing
to fixed financial targets three years in the future, in favour of a long-term, circa 2020 growth vision. The
"New Strategic Direction” consists of basic concepts on management policy together with business and
market strategies. It seeks to recognize the Company’s value and upside potential as a sogo
shosha capable of "providing stable earnings throughout business cycles by managing a portfolio
diversified by business model, industry, market and geography".
MC remains dedicated to sustainable growth but as evidenced by its guiding philosophy, the
"Three Corporate Principles", its business activities are even more committed to helping solve
problems in Japan and around the world. Its chief goal is to contribute to sustainable societal
growth on a global scale.
The summary of this New Strategic Direction is:
➢ Future pull approach eyeing 2020 with a vision to double the business by building a
diversified but focussed portfolio.
➢ Clear portfolio strategy: Select winning businesses through proactiv e reshaping of portfolio.
➢ Grow business and deliver returns while maintaining financial discipline.
TEST YOUR KNOWLEDGE

Theoretical Questions
1. Explain the Interface of Financial Policy and Strategic Management.
2. Write a short note on Balancing Financial Goals vis-a-vis Sustainable Growth.
Answers to Theoretical Questions

1. Please refer paragraph 4
2
RISK MANAGEMENT
LEARNING OUTCOMES
After going through the chapter student shall be able to understand:
❑ Identification of types of Risk faced by an organization
❑ Evaluation of Financial Risks
❑ Value at Risk (VAR)
❑ Evaluation of appropriate method for the identification and management
of financial risk.
1. IDENTIFICATION OF TYPES OF RISK FACED BY AN

ORGANIZATION
A business organization faces many types of risks. Important among them are discussed as below:
1.1 Strategic Risk
A successful business always needs a comprehensive and detailed business plan. Everyone
knows that a successful business needs a comprehensive, well-thought-out business plan but it’s
also a fact of life that, if things changes, even the best-laid plans can become outdated if it cannot
keep pace with the latest trends. This is what is called as strategic risk. So, strategic risk is a risk
in which a company’s strategy becomes less effective and it struggles to achieve its goal. It could
be due to technological changes, a new competitor entering the market, shifts in customer
demand, increase in the costs of raw materials, or any number of other large -scale changes.
We can take the example of Kodak which was able to develop a digital camera by 1975 but it
considers this innovation as a threat to its core business model, and failed to develop it. However,
it paid the price because when digital camera was ultimately discovered by other companies, it
failed to develop it and left behind. Similar example can be given in case of No kia when it failed to
upgrade its technology to develop touch screen mobile phones. That delay enables Samsung to
become a market leader in touch screen mobile phones.
However, a positive example can be given in the case of Xerox which invented photocopy
machine. When laser printing was developed, Xerox was quick to lap up this opportunity and
changes its business model to develop laser printing. So, it survived the strategic risk and
escalated its profits further.
1.2. Compliance Risk
Every business needs to comply with rules and regulations. For example with the advent of
Companies Act, 2013, and continuous updating of SEBI guidelines, each business organization
has to comply with plethora of rules, regulations and guidelines. Non compliance leads to pen alties
in the form of fine and imprisonment.
However, when a company ventures into a new business line or a new geographical area, the real
problem then occurs. For example, a company pursuing cement business likely to venture into
sugar business in a different state but laws applicable to the sugar mills in that state are different.
So, that poses a compliance risk. If the company fails to comply with laws related to a new area or
industry or sector, it will pose a serious threat to its survival.
1.3 Operational Risk
This type of risk relates to internal risk. It also relates to failure on the part of the company to cope
with day to day operational problems. Operational risk relates to ‘people’ as well as ‘process’. We
will take an example to illustrate this. For example, an employee paying out ` 1,00,000 from the
account of the company instead of ` 10,000.
This is a people as well as a process risk. An organization can employ another person to check the
work of that person who has mistakenly paid ` 1,00,000 or it can install an electronic system that
can flag off an unusual amount.
1.4 Financial Risk
Financial Risk is referred as the unexpected changes in financial conditions such as prices,
exchange rate, Credit rating, and interest rate etc. Though political risk is not a financial risk in
direct sense but same can be included as any unexpected political change in any foreign country
may lead to country risk which may ultimately may result in financial loss.
Accordingly, the broadly Financial Risk can be divided into following categories.
1.4.1 Counter Party Risk
This risk occurs due to non-honoring of obligations by the counter party which can be failure to
deliver the goods for the payment already made or vice-versa or repayment of borrowings and
interest etc. Thus, this risk also covers the credit risk i.e. default by the counter party.
RISK MANAGEMENT 2.3
1.4.2 Political Risk

Generally this type of risk is faced by and overseas investors, as the adverse action by the
government of host country may lead to huge loses. This can be on any of the following form.
• Confiscation or destruction of overseas properties.
• Rationing of remittance to home country.
• Restriction on conversion of local currency of host country into foreign currency.
• Restriction as to borrowings.
• Invalidation of Patents
• Price control of products
1.4.3. Interest Rate Risk
This risk occurs due to change in interest rate resulting in change in asset and liabilities. This risk
is more important for banking companies as their balance sheet’s items are more interest sensitive
and their base of earning is spread between borrowing and lending rates.
As we know that the interest rates are of two types i.e. fixed and floating. The risk in both of these
types is inherent. If any company has borrowed money at floating rate then with increase in
floating the liability under fixed rate shall remain the same. This fixed rate, with falling floating rate
the liability of company to pay interest under fixed rate shall comparatively be higher.
1.4.4 Currency Risk
This risk mainly affects the organization dealing with foreign exchange as their cash flows changes
with the movement in the currency exchange rates. This risk can be affected by cash flow
adversely or favorably. For example, if rupee depreciates vis-à-vis US$ receivables will stand to
gain vis-à-vis to the importer who has the liability to pay bill in US$. The best case we can quote
Infosys (Exporter) and Indian Oil Corporation Ltd. (Importer).
1.4.5 Liquidity Risk
Broadly liquidity risk can be defined as inability of organization to meet it liabilities whenever they
become due.
This risk mainly arises when organization is unable to generate adequate cash or there may be
some mismatch in period of cash flow generation.
This type of risk is more prevalent in banking business where there may be mismatch in maturities
and receiving fresh deposits pattern.
2. EVALUATION OF FINANCIAL RISK

The financial risk can be evaluated from different point of views as follows:
(a) From stakeholder’s point of view: Major stakeholders of a business are equity shareholders
and they view financial gearing i.e. ratio of debt in capital structure of company as risk since
in event of winding up of a company they will be least prioritized.
Even for a lender, existing gearing is also a risk since company having high gearing faces
more risk in default of payment of interest and principal repayment.
(b) From Company’s point of view: From company’s point of view if a company borrows
excessively or lend to someone who defaults, then it can be forced to go into liquidation.
(c) From Government’s point of view: From Government’s point of view, the financial risk can
be viewed as failure of any bank or (like Lehman Brothers) down grading of any financial
institution leading to spread of distrust among society at large. Even this risk also includes
willful defaulters. This can also be extended to sovereign debt crisis.
3. VALUE-AT-RISK (VAR)
As per Wikipedia, VAR is a measure of risk of investment. Given the normal market condition in a
set of period, say, one day it estimates how much an investment might lose. This investment can
be a portfolio, capital investment or foreign exchange etc., VAR answers two basic questions -
(i) What is worst case scenario?
(ii) What will be loss?
It was first applied in 1922 in New York Stock Exchange, entered the financial world in 1990s and
become world’s most widely used measure of financial risk.
3.1 Features of VAR
Following are main features of VAR
(i) Components of Calculations: VAR calculation is based on following three components :
(a) Time Period
(b) Confidence Level – Generally 95% and 99%
(c) Loss in percentage or in amount
(ii) Statistical Method: It is a type of statistical tool based on Standard Deviation.
(iii) Time Horizon: VAR can be applied for different time horizons say one day, one week, one
month and so on.
RISK MANAGEMENT 2.5
(iv) Probability: Assuming the values are normally attributed, probability of maximum loss can
be predicted.
(v) Risk Control: Risk can be controlled by setting limits for maximum loss.
(vi) Z Score: Z Score indicates how many standard Deviations is away from Mean value of a
population. When it is multiplied with Standard Deviation it provides VAR.
3.2 Application of VAR
VAR can be applied
(a) to measure the maximum possible loss on any portfolio or a trading position.
(b) as a benchmark for performance measurement of any operation or trading.
(c) to fix limits for individuals dealing in front office of a treasury department.
(d) to enable the management to decide the trading strategies.
(e) as a tool for Asset and Liability Management especially in banks.
3.3 Example:
The concept of VAR can be understood in a better manner with help of following example:
Suppose you hold worth ` 2 crore shares of X Ltd. whose market price standard deviation is 2%
per day. Assuming 252 trading days a year, determine maximum loss level over the period of 1
trading day and 10 trading days with 99% confidence level.
Answer
Assuming share prices are normally distributed for level of 99%, the equivalent Z score from
Normal table of Cumulative Area shall be 2.33.
Volatility in terms of rupees shall be:
2% of ` 2 Crore = ` 4 lakh
The maximum loss for 1 day at 99% Confidence Level shall be:
` 4 lakh x 2.33 = ` 9.32 lakh,
and expected maximum loss for 10 trading days shall be:
√10 x ` 9.32 lakh = 29.47 lakhs
4. APPROPRIATE METHODS FOR IDENTIFICATION AND

MANAGEMENT OF FINANCIAL RISK
As we have classified financial risk in 4 categories, we shall discuss identification and
management of each risk separately under same category.
4.1 Counter Party risk

The various hints that may provide counter party risk are as follows:
(a) Failure to obtain necessary resources to complete the project or transaction undertaken.
(b) Any regulatory restrictions from the Government.
(c) Hostile action of foreign government.
(d) Let down by third party.
(e) Have become insolvent.
The various techniques to manage this type of risk are as follows:
(1) Carrying out Due Diligence before dealing with any third party.
(2) Do not over commit to a single entity or group or connected entities.
(3) Know your exposure limits.
(4) Review the limits and procedure for credit approval regularly.
(5) Rapid action in the event of any likelihood of defaults.
(6) Use of performance guarantee, insurance or other instruments.
4.2 Political risk
From the following actions by the Governments of the host country this risk can be identified:
1. Insistence on resident investors or labour.
2. Restriction on conversion of currency.
3. Expropriation of foreign assets by the local govt.
4. Price fixation of the products.
Since this risk mainly relates to investments in foreign country, company should assess country
risk
(1) By referring political ranking published by different business magazines.
(2) By evaluating country’s macro-economic conditions.
(3) By analyzing the popularity of current government and assess their stability.
(4) By taking advises from the embassies of the home country in the host countries.
Further, following techniques can be used to mitigate this risk.
(i) Local sourcing of raw materials and labour.
(ii) Entering into joint ventures
RISK MANAGEMENT 2.7
(iii) Local financing

(iv) Prior negotiations
4.3 Interest Rate Risk
Generally, interest rate Risk is mainly identified from the following:
1. Monetary Policy of the Government.
2. Any action by Government such as demonetization etc.
3. Economic Growth
4. Release of Industrial Data
5. Investment by foreign investors
6. Stock market changes
The management of Interest risk has been discussed in detail in separate chapter later on.
4.4 Currency Risk
Just like interest rate risk the currency risk is dependent on the Government action and economic
development. Some of the parameters to identity the currency risk are as follows:
(1) Government Action: The Government action of any country has visual impact in its
currency. For example, the UK Govt. decision to divorce from European Union i.e. Brexit
brought the pound to its lowest since 1980’s.
(2) Nominal Interest Rate: As per interest rate parity (IRP) the currency exchange rate depends
on the nominal interest of that country.
(3) Inflation Rate: Purchasing power parity theory discussed in later chapters impact the value
of currency.
(4) Natural Calamities: Any natural calamity can have negative impact.
(5) War, Coup, Rebellion etc.: All these actions can have far reaching impact on currency’s
exchange rates.
(6) Change of Government: The change of government and its attitude towards foreign
investment also helps to identify the currency risk.
So far as the management of currency risk is concerned, it has been covered in a detaiedl manner
in a separate chapter.
TEST YOUR KNOWLEDGE

1. Explain the significance of VAR.
2. The Financial Risk can be viewed from different perspective. Explain.
Practical Questions
1. Consider a portfolio consisting of a ` 200,00,000 investment in share XYZ and a
` 200,00,000 investment in share ABC. The daily standard deviation of both shares is 1%
and that the coefficient of correlation between them is 0.3. You are required to determine
the 10-day 99% value at risk for the portfolio?
ANSWERS/ SOLUTIONS
1. Please refer paragraph 3.2
Answers to the Practical Questions
1. The standard deviation of the daily change in the investment in each asset is ` 2,00,000 i.e.
2 lakhs. The variance of the portfolio’s daily change is
V = 22 + 22 + 2 x 0.3 x 2 x 2 = 10.4
σ (Standard Deviation) = 10.4 = ` 3.22 lakhs

Alternatively, it can also be computed as follows:
= (1)2(0.50)2 + (1)2(0.50)2 + 2(1)(1)(0.3)(0.50)(0.50)
= 0.25 + 0.25 + 0.15 = 0.65%
σ (Standard Deviation) = 0.65 = 0.80623%
σ (Standard Deviation) in Amount = ` 400 lakhs x 0.80623% = ` 3.22 lakhs
Accordingly, the standard deviation of the 10-day change is
` 3.22 lakhs x 10 = ` 10.18 lakh

From the Normal Table we see that z score for 1% is 2.33. This means that 1% of a normal
distribution lies more than 2.33 standard deviations below the mean. The 10-day 99 percent
value at risk is therefore
2.33 × ` 10.18 lakh = ` 23.72 lakh
3
SECURITY ANALYSIS
LEARNING OUTCOMES
❑ Fundamental Analysis
❑ Technical Analysis
(a) Meaning
(b) Assumptions
(c) Theories and Principles
(d) Charting Techniques
❑ Efficient Market Hypothesis (EMH) Analysis
INTRODUCTION
Investment decision depends on securities to be bought, held or sold. Buying security is based on
highest return per unit of risk or lowest risk per unit of return. Selling security does not depend on
any such requirement. A security considered for buying today may not be attractive tomorrow due
to management policy changes in the company or economic policy changes adopted by the
government. The reverse is also true. Therefore, analysis of the security on a continuous basis is a
must.
Security Analysis involves a systematic analysis of the risk return profiles of various securities
which is to help a rational investor to estimate a value for a company from all the price sensitive
information/data so that he can make purchases when the market under-prices some of them and
thereby earn a reasonable rate of return.
Two approaches viz. fundamental analysis and technical analysis are in vogue for carrying out
Security Analysis. In fundamental analysis, factors affecting risk-return characteristics of securities
are looked into while in technical analysis, demand/ supply position of the securities along with
prevalent share price trends are examined.
1. FUNDAMENTAL ANALYSIS
Fundamental Analysis is based on the assumption that the share prices depend upon the future
dividends expected by the shareholders. The present value of the future dividends can be
calculated by discounting the cash flows at an appropriate discount rate and is known as the
'intrinsic value of the share'. The intrinsic value of a share, according to a fundamental analyst,
depicts the true value of a share. A share that is priced below the intrinsic value must be bought,
while a share quoting above the intrinsic value must be sold.
Thus, it can be said that the price the shareholders are prepared to pay for a share is nothing but
the present value of the dividends they expect to receive on the share and this is the price at which
they expect to sell it in the future.
As a first step, to arrive at a compact expression, let us make a simple assumption, that the
company is expected to pay a uniform dividend of ` D per share every year, i.e.,
D(1) = D(2) = D(3) = … = D, (1)
The Eq., would then become:
D D D
P(0) = + 2
+ + ... + ... (2)
(1+ k) (1+ k) (1+ k)3
D
and P(0) = (3)
k
But it is unrealistic to assume that dividends remain constant over time. In case of most shares,
the dividends per share (DPS) grow because of the growth in the earnings of the firm. Most
companies, as they identify new investment opportunities for growth, tend to increase their DPS
over a period of time.
Let us assume that on an average the DPS of the company grows at the compounded rate of g per
annum, so that dividend D(1) at the end of the first period grows to D(1)(1+g), D(1)(1+g)2, etc, at
the end of second period, third period, etc. respectively. So we must have:
D (1) D (1) (1 + g) D (1) (1 + g)2
P(0) = + + + ... + ... (4)
(1 + k) (1 + k)2 (1 + k)3
which is a perpetual geometric series.
SECURITY ANALYSIS 3.3
If growth rate in dividends, g, is less than the desired rate of return on share, k, we must have:
D(1)
P(0) = (5)
(k − g)
or
D(0)(1 + g)
P(0) = (6)
(k − g)
Since D(1) may be approximated as D(0)(1+g), D(0) being the DPS in the current period (0).
When growth rate in dividends, g, is equal to or greater than the desired rate of return on share, k,
the above model is not valid, since the geometric series leads to an infinite price. The condition
that g be less than k is not very restrictive, since the long-term growth in dividends is unlikely to
exceed the rate of return expected by the market on the share.
The above result [Eq.(5)] is also known as Gordon’s dividend growth model for stock valuation,
named after the model’s originator, Myron J. Gordon. This is one of the most well-known models in
the genre of fundamental analysis.
In equation (6), if “g” is set at zero, we get back equation (3).
1.1 Dividend Growth Model and the PE Multiple
Financial analysts tend to relate price to earnings via the P/E multiples (the ratio between the
market price and earnings per share).
If a company is assumed to pay out a fraction b of its earnings as dividends on an average (i.e. the
Dividend Payout Ratio = b), D(1) may be expressed as b E(1), where E(1) is the earning per share
(EPS) of the company at the end of the first period. Equation (5) then becomes:
bE(1)
P(0) = (7)
(k − g)
or
bE(0) (1 + g)
P(0) = (8)
(k − g)
The fundamental analysts use the above models or some of their variations, for estimating the
fundamental or intrinsic price or the fundamental price-earnings multiple of a security. Towards this
end, they devote considerable effort in assessing the impact of various kinds of information on a
company’s future profitability and the expected return of the shareholders. If the prevailing price or
the P/E multiple of a security is higher than the estimated fundamental value (i.e. if the security
appears to be overpriced), they recommend a selling stance with respect to that security, since
once the information becomes common knowledge, the price of the security may be expected to
fall. On the other hand, if the security is underpriced in the market, the prevailing price (or the P/E
multiple) of the security being lower than the estimated fundamental value, they recommend
buying the security, counting upon a price rise.
Because of these inherent complex interrelationships in the production processes, the fortunes of
each industry are closely tied to those of other industries and to the performance of the economy
as a whole. Within an industry, the prospects of a specific company depend not only on the
prospects of the industry to which it belongs, but also on its operating and competitive position
within that industry. The key variables that an investor must monitor in order to carry out his
fundamental analysis are economy wide factors, industry wide factors and company specific
factors. In other words, fundamental analysis encompasses economic, industrial and company
analyses. They are depicted by three concentric circles and constitute the different stages in an
investment decision making process.
Economy Analysis
Industry Analysis
Company Analysis
1.2 Economic Analysis

Macro- economic factors e.g. historical performance of the economy in the past/ present and
expectations in future, growth of different sectors of the economy in future with signs of
stagnation/degradation at present to be assessed while analyzing the overall economy. Trends in
peoples’ income and expenditure reflect the growth of a particular industry/company in future.
Consumption affects corporate profits, dividends and share prices in the market.
1.2.1 Factors Affecting Economic Analysis
Some of the economy wide factors are discussed as under:
(a) Growth Rates of National Income and Related Measures: For most purposes, what is
important is the difference between the nominal growth rate quoted by GDP and the ‘real’ growth
after taking inflation into account. The estimated growth rate of the economy would be a pointer to
the prospects for the industrial sector, and therefore to the returns investors can expect from
investment in shares.
(b) Growth Rates of Industrial Sector: This can be further broken down into growth rates of
various industries or groups of industries if required. The growth rates in various industries are
estimated based on the estimated demand for its products.
(c) Inflation: Inflation is measured in terms of either wholesale prices (the Wholesale Price
Index or WPI) or retail prices (Consumer Price Index or CPI). The demand in some industries,
particularly the consumer products industries, is significantly influenced by the inflation rate.
Therefore, firms in these industries make continuous assessment about inflat ion rates likely to
prevail in the near future so as to fine-tune their pricing, distribution and promotion policies to the
anticipated impact of inflation on demand for their products.
(d) Monsoon: Because of the strong forward and backward linkages, monsoon is of great
concern to investors in the stock market too.
1.2.2 Techniques Used in Economic Analysis

Economic analysis is used to forecast national income with its various components that have a
bearing on the concerned industry and the company in particular. Gross National Product (GNP) is
used to measure national income as it reflects the growth rate in economic activities and has been
regarded as a forecasting tool for analyzing the overall economy along with its various components
during a particular period.
Some of the techniques used for economic analysis are:
(a) Anticipatory Surveys: They help investors to form an opinion about the future state of the
economy. It incorporates expert opinion on construction activities, expenditure on plant and
machinery, levels of inventory – all having a definite bearing on economic activities. Also future
spending habits of consumers are taken into account.
In spite of valuable inputs available through this method, it has certain drawbacks:
(i) Survey results do not guarantee that intentions surveyed would materialize.
(ii) They are not regarded as forecasts per se, as there can be a consensus approach by the
investor for exercising his opinion.
Continuous monitoring of this practice is called for to make this technique popular.
(b) Barometer/Indicator Approach: Various indicators are used to find out how the economy
shall perform in the future. The indicators have been classified as under:
(i) Leading Indicators: They lead the economic activity in terms of their outcome. They relate to
the time series data of the variables that reach high/low points in advance of economic
activity.
(ii) Roughly Coincidental Indicators: They reach their peaks and troughs at approximately the
same in the economy.
(iii) Lagging Indicators: They are time series data of variables that lag behind in their
consequences vis-a- vis the economy. They reach their turning points after the economy
has reached its own already.
All these approaches suggest direction of change in the aggregate economic activity but nothing
about its magnitude. The various measures obtained form such indicators may give conflicting
signals about the future direction of the economy. To avoid this limitation, use of
diffusion/composite index is suggested whereby combining several indicators into one index to
measure the strength/weaknesses in the movement of a particular set of indicators. Computation
of diffusion indices is no doubt difficult notwithstanding the fact it does not eliminate irregular
movements.
Money supply in the economy also affects investment decisions. Rate of change in money supply
in the economy affects GNP, corporate profits, interest rates and stock prices. Increase in money
supply fuels inflation. As investment in stocks is considered as a hedge against inflation, stock
prices go up during inflationary period.
(c) Economic Model Building Approach: In this approach, a precise and clear relationship
between dependent and independent variables is determined. GNP model bu ilding or sectoral
analysis is used in practice through the use of national accounting framework. The steps used are
as follows:
(i) Hypothesize total economic demand by measuring total income (GNP) based on political
stability, rate of inflation, changes in economic levels.
(ii) Forecasting the GNP by estimating levels of various components viz. consumption
expenditure, gross private domestic investment, government purchases of goods/services,
net exports.
(iii) After forecasting individual components of GNP, add them up to obtain the forecasted GNP.
(iv) Comparison is made of total GNP thus arrived at with that from an independent agency for
the forecast of GNP and then the overall forecast is tested for consistency. This is carried
out for ensuring that both the total forecast and the component wise forecast fit together in
a reasonable manner.
1.3 Industry Analysis
When an economy grows, it is very unlikely that all industries in the economy would grow at the
same rate. So it is necessary to examine industry specific factors, in addition to economy-wide
factors.
First of all, an assessment has to be made regarding all the conditions and factors relating to
demand of the particular product, cost structure of the industry and other economic and
Government constraints on the same. Since the basic profitability of any company depends upon
the economic prospects of the industry to which it belongs, an appraisal of the particular industry's
prospects is essential.
1.3.1 Factors Affecting Industry Analysis
The following factors may particularly be kept in mind while assessing the factors relating to an
industry.
(a) Product Life-Cycle: An industry usually exhibits high profitability in the initial and growth
stages, medium but steady profitability in the maturity stage and a sharp decline in
profitability in the last stage of growth.
(b) Demand Supply Gap: Excess supply reduces the profitability of the industry because of
the decline in the unit price realization, while insufficient supply tends to improve the
profitability because of higher unit price realization.
(c) Barriers to Entry: Any industry with high profitability would attract fresh investments. The
potential entrants to the industry, however, face different types of barriers to entry. Some of
these barriers are innate to the product and the technology of production, while other
barriers are created by existing firms in the industry.
(d) Government Attitude: The attitude of the government towards an industry is a crucial
determinant of its prospects.
(e) State of Competition in the Industry: Factors to be noted are- firms with leadership
capability and the nature of competition amongst them in foreign and domestic market, type
of products manufactured viz. homogeneous or highly differentiated, demand prospects
through classification viz customer-wise/area-wise, changes in demand patterns in the
long/immediate/ short run, type of industry the firm is placed viz. growth, cyclical, defensive
or decline.
(f) Cost Conditions and Profitability: The price of a share depends on its return, which in
turn depends on profitability of the firm. Profitability depends on the state of competition in
the industry, cost control measures adopted by its units and growth in demand for its
products.
Factors to be considered are:
(i) Cost allocation among various heads e.g. raw material, labours and overheads and
their controllability. Overhead cost for some may be higher while for others labour
may be so. Labour cost which depends on wage level and productivity needs close
scrutiny.
(ii) Product price.
(iii) Production capacity in terms of installation, idle and operating.
(iv) Level of capital expenditure required for maintenance / increase in productive

efficiency.
Investors are required to make a through analysis of profitability. This is carried out by the
study of certain ratios such as G.P. Ratio, Operating Profit Margin Ratio, R.O.E., Return on
Total Capital etc.
(g) Technology and Research: They play a vital role in the growth and survival of a particular
industry. Technology is subject to change very fast leading to obsolescence. Industries
which update themselves have a competitive advantage over others in terms of quality,
price etc.
Things to be probed in this regard are:
(i) Nature and type of technology used.
(ii) Expected changes in technology for new products leading to increase in sales.
(iii) Relationship of capital expenditure and sales over time. More capital expenditure
means increase in sales.
(iv) Money spent in research and development. Whether this amount relates to
redundancy or not?
(v) Assessment of industry in terms of sales and profitability in short, immediate and
long run.
1.3.2 Techniques Used in Industry Analysis
The techniques used for analyzing the industry wide factors are:
(a) Regression Analysis: Investor diagnoses the factors determining the demand for output of
the industry through product demand analysis. Factors to be considered are GNP,
disposable income, per capita consumption / income, price elasticity of demand. For
identifying factors affecting demand, statistical techniques like regression analysis and
correlation are used.
(b) Input – Output Analysis: It reflects the flow of goods and services through the economy,
intermediate steps in production process as goods proceed from raw material stage through
final consumption. This is carried out to detect changing patterns/trends indicating
growth/decline of industries.
1.4 Company Analysis
Economic and industry framework provides the investor with proper background against which
shares of a particular company are purchased. This requires careful examination of the company's
quantitative and qualitative fundamentals.
(a) Net Worth and Book Value: Net Worth is sum of equity share capital, preference share
capital and free reserves less intangible assets and any carry forward of losses. The total
net worth divided by the number of shares is the much talked about book value of a share.
Though the book value is often seen as an indication of the intrinsic worth of the share, this
may not be so for two major reasons. First, the market price of the share reflects the future
earnings potential of the firm which may have no relationship with the value of its asse ts.
Second, the book value is based upon the historical costs of the assets of the firm and
these may be gross underestimates of the cost of the replacement or resale values of these
assets.
(b) Sources and Uses of Funds: The identification of sources and uses of funds is known as
Funds Flow Analysis. One of the major uses of funds flow analysis is to find out whether the
firm has used short-term sources of funds to finance long-term investments. Such methods
of financing increases the risk of liquidity crunch for the firm, as long-term investments,
because of the gestation period involved may not generate enough surpluses in time to
meet the short-term liabilities incurred by the firm. Many a firm has come to grief because of
this mismatch between the maturity periods of sources and uses of funds.
(c) Cross-Sectional and Time Series Analysis: One of the main purposes of examining
financial statements is to compare two firms, compare a firm against some benchmark
figures for its industry and to analyze the performance of a firm over time. The techniques
that are used to do such proper comparative analysis are: common-sized statement, and
financial ratio analysis.
(d) Size and Ranking: A rough idea regarding the size and ranking of the company within the
economy, in general, and the industry, in particular, would help the investment manager in
assessing the risk associated with the company. In this regard the net capital employed, the
net profits, the return on investment and the sales figures of the company under
consideration may be compared with similar data of other companies in the same industry
group. It may also be useful to assess the position of the company in terms of technical
know-how, research and development activity and price leadership.
(e) Growth Record: The growth in sales, net income, net capital employed and earnings per
share of the company in the past few years should be examined. The following three growth
indicators may be particularly looked into: (a) Price earnings ratio, (b) Percentage growth
rate of earnings per annum, and (c) Percentage growth rate of net block.
The price earnings ratio is an important indicator for the investment manager since it shows the
number of times the earnings per share are covered by the market price of a share. Theoretically,
this ratio should be the same for two companies with similar features. However, this is not so in
practice due to many factors. Hence, by a comparison of this ratio pertaining to different
companies the investment manager can have an idea about the image of the company and can
determine whether the share is under-priced or over-priced.
Consider the following example:
Company A Company B
(a) Market price of share of ` 100 150 250
(b) Earnings per share 25 25
(c) Price earnings ratio [ (a) ÷ (b) ] 6 10
It is obvious that the purchaser of company A's shares pays 6 times its annual earnings while the
purchaser of company B's shares pays 10 times. If other factors (intrinsic value of share, growth
potential, etc.) are quite similar, it is obvious that the shares of company A are preferable. In
practice, however, the other factors are never similar in the case of two companies. The
investment manager must try to ascertain why the EPS in company B is comparatively low – may
be some factors are not apparent. EPS calculation cannot be the sole basis of deciding about an
investment. Yet it is one of the most important factors on the basis of which the investment
manager takes a decision to purchase the shares. This is because it relates the market price of the
shares and the earnings per share.
The percentage growth rate of net blocks shows how the company has been developing its
capacity levels. Obviously, a dynamic company will keep on expanding its capacities and diversify
its business. This will enable it to enter new and profitable lines and avoid stagnation in its growth.
In this context, an evaluation of future growth prospects of the company should be carefully made.
This requires an analysis of existing capacities and their utilisation, proposed expansion and
diversification plans and the nature of the company's technology. The existing capacity utilisation
levels can be known from the quantitative information given in the published profit and loss
accounts of the company. The plans of the company, in terms of expansion or diversi fication, can
be known from the Directors’ Reports, the Chairman’s statements and from the future capital
commitments as shown by way of notes in the balance sheets. The nature of technology of a
company should be seen with reference to technological developments in the concerned fields, the
possibility of its product being superseded or the possibility of emergence of a more effective
method of manufacturing.
Growth is the single most important factor in company analysis for the purpose of investment
management. A company may have a good record of profits and performance in the past; but if it
does not have growth potential, its shares cannot be rated high from the investment point of view.
(f) Financial Analysis: An analysis of its financial statements for the past few years would
help the investment manager in understanding the financial solvency and liquidity, the efficiency
with which the funds are used, the profitability, the operating efficiency and the financial and
operating leverages of the company. For this purpose, certain fundamental ratios have to be
calculated.
From the investment point of view, the most important figures are earnings per share, price
earning ratios, yield, book value and the intrinsic value of the share. These five elements may be
calculated for the past 10 years or so and compared with similar ratios computed from the financial
accounts of other companies in the industry and with the average ratios for the industry as a
whole. The yield and the asset backing of a share are important considerations in a decision
regarding whether the particular market price of the share is proper or not.
Various other ratios to measure profitability, operating efficiency and turnover efficiency of the
company may also be calculated. The return on owners' investment, capital turnover ratio and the
cost structure ratios may also be worked out.
To examine the financial solvency or liquidity of the company, the investment manager may work
out current ratio, liquidity ratio, debt-equity ratio, etc. These ratios will provide an overall view of
the company to the investment analyst. He can analyse its strengths and weaknesses and see
whether it is worth the risk or not.
(g) Competitive Advantage: Another business consideration for investors is competitive
advantage. A company's long-term success is driven largely by its ability to maintain its
competitive advantage. Powerful competitive advantages, such as Apple’s brand name and
Samsung’s domination of the mobile market, create a shield around a business that allows it to
keep competitors at a distance.
(h) Quality of Management: This is an intangible factor. Yet it has a very important bearing on
the value of the shares. Every investment manager knows that the shares of certain business
houses command a higher premium than those of similar companies managed by other business
houses. This is because of the quality of management, the confidence that investors have in a
particular business house, its policy vis-a-vis its relationship with the investors, dividend and
financial performance record of other companies in the same group, etc. This is perhaps the
reason that an investment manager always gives a close look to the management of a company in
whose shares he is to invest. Quality of management has to be seen with reference to the
experience, skills and integrity of the persons at the helm of affairs of the company. The policy of
the management regarding relationship with the shareholders is an important factor since certain
business houses believe in very generous dividend and bonus distributions while others are rather
conservative.
However, an average investor is at a disadvantage when compared with a large investor. They do
not get the facility to meet the top executives of the company, but the fund managers interested in
investing huge amount of money generally get to meet the top brasses of an organization.
It is true that every listed company give detailed information about its management. But, the
information they give is always positive. This is because; no company will host any negative
information about its company. So, the question is how to find the dirt inside the management. The
remedy is to have a look out for the conference calls hosted by the company’s CEO and CFO.
After reading the company’s financial results, they take question and answers session from the
investors. That’s where one can pick something that can indicate about the true position about the
company.
Some other ways to judge the management of the company is to read the Management Discussion
and Analysis Report. Further, it helps when top management people are also the shareholders. If
the large scale unloading of their shares are taking place and something else is communicated to
the media, then it is a sign that something is wrong. Another way to judge the effectiveness of the
management is to see the past performance of the executives, say, for five years.
(i) Corporate Governance: Following factors are to be kept in mind while judging the
effectiveness of corporate governance of an organization:
• Whether company is complying with all aspects of SEBI (LODR) Regulations 2015?
• How well corporate governance policies serve stakeholders?
• Quality and timeliness of company financial disclosures.
• Whether quality independent directors are inducted.
(j) Regulation: Regulations plays an important role in maintaining the sanctity of the corporate
form of organization. In Indian listed companies, Companies Act, Securities Contract and
Regulation Act and SEBI Act basically look after regulatory aspects of a company. A listed
company is also continuously monitored by SEBI which through its guidelines and regulations
protect the interest of investors.
Further, a company which is dealing with companies outside India, needs to comply with Foreign
Exchange Management Act (FEMA) also. In this scenario, the Reserve Bank of India (RBI) does a
continuous monitoring.
(k) Location and Labour-Management Relations: The locations of the company's
manufacturing facilities determines its economic viability which depends on the availabi lity of
crucial inputs like power, skilled labour and raw-materials, etc. Nearness to markets is also a factor
to be considered.
In the past few years, the investment manager has begun looking into the state of labour -
management relations in the company under consideration and the area where it is located.
(l) Pattern of Existing Stock Holding: An analysis of the pattern of existing stock holdings of
the company would also be relevant. This would show the stake of various parties in the company.
An interesting case in this regard is that of the Punjab National Bank in which the Life Insurance
Corporation and other financial institutions had substantial holdings. When the bank was
nationalised, the residual company proposed a scheme whereby those shareholde rs, who wish to
opt out, could receive a certain amount as compensation in cash. It was only at the instance and
the bargaining strength, of institutional investors that the compensation offered to the
shareholders, who wished to opt out of the company, was raised considerably.
(m) Marketability of the Shares: Another important consideration for an investment manager is
the marketability of the shares of the company. Mere listing of a share on the stock exchange does
not automatically mean that the share can be sold or purchased at will. There are many shares
which remain inactive for long periods with no transactions being affected. To purchase or sell
such scrips is a difficult task. In this regard, dispersal of shareholding with special reference to the
extent of public holding should be seen. The other relevant factors are the speculative interest in
the particular scrip, the particular stock exchange where it is traded and the volume of trading.
1.4.1 Techniques Used in Company Analysis
Through the use of statistical techniques the company wide factors can be analyzed. Some of the
techniques are discussed as under:
(a) Correlation & Regression Analysis: Simple regression is used when inter relationship
covers two variables. For more than two variables, multiple regression analysis is followed. Here
the inter relationship between variables belonging to economy, industry and company are found
out. The main advantage in such analysis is the determination of the forecasted values along with
testing the reliability of the estimates.
(b) Trend Analysis: The relationship of one variable is tested over time using regression
analysis. It gives an insight to the historical behavior of the variable.
(c) Decision Tree Analysis: Information relating to the probability of occurrence of the
forecasted value is considered useful. A range of values of the variable with probabilities of
occurrence of each value is taken up. The limitations are reduced through decision tree analysis
and use of simulation techniques.
In decision tree analysis, the decision is taken sequentially with probabilities attached to each
sequence. To obtain the probability of final outcome, various sequential decisions given along with
probabilities, the probabilities of each sequence is to be multiplied and them summed up.
Thus, fundamental analysis is basically an examination of the economic and financial aspects of a
company with the aim of estimating future earnings and dividend prospects. It includes an analysis
of the macro-economic and political factors which will have an impact on the performance of the
company. After having analysed all the relevant information about the company and its relative
strength vis-a-vis other companies in the industry, the investor is expected to decide whether he
should buy or sell the securities.
Apart from these, the Group Analysis has also become an important factor. SEBI, in particular,
emphasizes the need for disclosure, in public offer documents, of all relevant parameters –
especially the financial health and promise versus performance of the group companies. RBI has
also been focusing more and more on the Group Exposure Norms of commercial Banks.
2. TECHNICAL ANALYSIS
2.1 Meaning
Technical Analysis is a method of share price movements based on a study of price graphs or
charts on the assumption that share price trends are repetitive, that since investor psychology
follows a certain pattern, what is seen to have happened before is likely to be repeated. The
technical analyst is concerned with the fundamental strength or weakness of a company or an
industry; he studies investor and price behaviour.
A technical analyst attempts to answer two basic questions:
(i) Is there a discernible trend in the prices?
(ii) If there is, then are there indications that the trend would reverse?
The methods used to answer these questions are visual and statistical. The visual methods are
based on examination of a variety of charts to make out patterns, while the statistical procedures
analyse price and return data to make trading decisions.
2.2 Assumptions
Technical Analysis is based on the following assumptions:
(i) The market value of stock depends on the supply and demand for a security.
(ii) The supply and demand are actually governed by several factors which can be rational or
irrational. For instance, recent initiatives taken by the Government to reduce the Non-
Performing Assets (NPA) burden of banks may result in the demand for banking stocks.
(iii) Stock prices generally move in trends which continue for a substantial period of time.
Therefore, if there is a bull market going on, there is every possibility that there will so on be
a substantial correction which will provide an opportunity to the investors to buy shares at
that time.
(iv) Technical analysis relies upon chart analysis which shows the past trends in stock prices
rather than the information in the financial statements like balance sheet or profit and loss
account.
2.3 Principles of Technical Analysis
Technical analysis is based on the following three principals:
a. The market discounts everything.
b. Price moves in trends.
c. History tends to repeat itself.
a. The Market Discounts Everything: Although many experts criticize technical analysis
because it only considers price movements and ignores fundamental factors but
the Efficient Market Hypothesis (discussed later in detail) contradicts it according to which a
company’s share price already reflects everything that has or could affect a company and it
includes fundamental factors. So, technical analysts generally have the view that a
company’s share price includes everything including the fundamentals of a company.
b. Price Moves in Trends: Technical analysts believe that prices move in trends. In other
words, a stock price is more likely to continue a past trend than move in a different
direction.
c. History Tends to Repeat Itself: Technical analysts believe that history tends to repeat
itself. Technical analysis uses chart patterns to analyze subsequent market movements to
understand trends. While many form of technical analysis have been used for many years,
they are still considered to be significant because they illustrate patterns in price
movements that often repeat themselves.
2.4 Theories of Technical Analysis
2.4.1 The Dow Theory
The Dow Theory is one of the oldest and most famous technical theories. It was originated by
Charles Dow, the founder of Dow Jones Company in late nineteenth century. It is a helpful tool for
determining the relative strength of the stock market. It can also be used as a barometer of
business.
The Dow Theory is based upon the movements of two indices, constructed by Charles Dow, Dow
Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA). These averages
reflect the aggregate impact of all kinds of information on the market. The movements of the
market are divided into three classifications, all going at the same time; the primary movement , the
secondary movement, and the daily fluctuations. The primary movement is the main trend of the
market, which lasts from one year to 36 months or longer. This trend is commonly called bear or
bull market. The secondary movement of the market is shorter in duration than the primary
movement, and is opposite in direction. It lasts from two weeks to a month or more. The daily
fluctuations are the narrow movements from day-to-day. These fluctuations are not part of the Dow
Theory interpretation of the stock market. However, daily movements must be carefully studied,
along with primary and secondary movements, as they go to make up the longer movement in the
market.
Thus, the Dow Theory’s purpose is to determine where the market is and where is it going,
although not how far or high. The theory, in practice, states that if the cyclical swings of the stock
market averages are successively higher and the successive lows are higher, then the market
trend is up and a bullish market exists. Contrarily, if the successive highs and successive lows are
lower, then the direction of the market is down and a bearish market exists.
Charles Dow proposed that the primary uptrend would have three moves up, the first one being
caused by accumulation of shares by the far-sighted, knowledgeable investors, the second move
would be caused by the arrival of the first reports of good earnings by corporations, and the last
move up would be caused by widespread report of financial well-being of corporations. The third
stage would also see rampant speculation in the market. Towards the end of the third stage, the
far-sighted investors, realizing that the high earnings levels may not be sustained, would start
selling, starting the first move down of a downtrend, and as the non-sustainability of high earnings
is confirmed, the second move down would be initiated and then the third move down would result
from distress selling in the market.
2.4.2 Elliot Wave Theory
Inspired by the Dow Theory and by observations found throughout nature, Ralp h Elliot formulated
Elliot Wave Theory in 1934. This theory was based on analysis of 75 years stock price movements
and charts. From his studies, he defined price movements in terms of waves. Accordingly, this
theory was named Elliot Wave Theory. Elliot found that the markets exhibited certain repeated
patterns or waves. As per this theory wave is a movement of the market price from one change in
the direction to the next change in the same direction. These waves are resulted from buying and
selling impulses emerging from the demand and supply pressures on the market. Depending on
the demand and supply pressures, waves are generated in the prices.
As per this theory, waves can be classified into two parts:-
• Impulsive patterns
• Corrective patters
Let us discuss each of these patterns.
(a) Impulsive Patterns-(Basic Waves) - In this pattern there will be 3 or 5 waves in a given
direction (going upward or downward). These waves shall move in the direction of the basic
movement. This movement can indicate bull phase or bear phase.
(b) Corrective Patterns- (Reaction Waves) - These 3 waves are against the basic direction of
the basic movement. Correction involves correcting the earlier rise in case of bull market
and fall in case of bear market.
As shown in the following diagram waves 1, 3 and 5 are directional movements, which are
separated or corrected by wave 2 & 4, termed as corrective movements.
Source: http://elliotwave.net/
Complete Cycle -As shown in following figure five-wave impulses is following by a three-
wave correction (a,b & c) to form a complete cycle of eight waves.
Source: http://elliotwave.net/
One complete cycle consists of waves made up of two distinct phases, bullish and bearish. On
completion of full one cycle i.e. termination of 8 waves movement, the fresh cycle starts with similar
impulses arising out of market trading.
2.4.3 Random Walk Theory
While discussing the Dow Jones theory, we have seen that the theory is based on the assumption
that the behaviour of stock market itself contains trends which give clues to the future behaviour of
stock market prices. Thus supporters of the theory argue that market prices can be predicted if
their patterns can be properly understood. Such analysis of stock market patterns is called
technical analysis. Apart from this theory there are many approaches to technical analysis. Most of
them, however, involve a good deal of subjective judgment.
Many investment managers and stock market analysts believe that stock market prices can never
be predicted because they are not a result of any underlying factors but are mere statistical ups
and downs. This hypothesis is known as Random Walk hypothesis which states that the behaviour
of stock market prices is unpredictable and that there is no relationship between the present prices
of the shares and their future prices. Proponents of this hypothesis argue that stock market prices
are independent. A British statistician, M. G. Kendell, found that changes in security prices behave
nearly as if they are generated by a suitably designed roulette wheel for which each outcome is
statistically independent of the past history. In other words, the fact that there a re peaks and
troughs in stock exchange prices is a mere statistical happening – successive peaks and troughs
are unconnected. In the layman's language it may be said that prices on the stock exchange
behave exactly the way a drunk would behave while walking in a blind lane, i.e., up and down, with
an unsteady way going in any direction he likes, bending on the side once and on the other side
the second time.
The supporters of this theory put out a simple argument. It follows that:
(a) Prices of shares in stock market can never be predicted.
(b) The reason is that the price trends are not the result of any underlying factors, but that they
represent a statistical expression of past data.
(c) There may be periodical ups or downs in share prices, but no connection can be
established between two successive peaks (high price of stocks) and troughs (low price of
stocks).
2.5 Charting Techniques
Broadly technical analysts use four types of charts for analyzing data. They are as follows:
(i) Line Chart: In a line chart, lines are used to connect successive day’s prices. The closing
price for each period is plotted as a point. These points are joined by a line to form the chart. The
period may be a day, a week or a month.
(ii) Bar Chart: In a bar chart, a vertical line (Bar) represents the lowest to the highest price,
with a short horizontal line protruding from the bar representing both the opening and closing
prices for the period. For example, the prices of share of A Ltd. for 6 days are as follows:
Days Opening Price (`) High Price (`) Low Price (`) Closing Price (`)
01-Jan 58 72 52 68
02-Jan 71 73 58 64.30
03-Jan 66 67 56 57
04-Jan 58.50 75.50 55 72
05-Jan 73.50 75 58 71
06-Jan 74.50 76 55 74.50
The above-mentioned prices shall be depicted in Bar Chart as follows:
(iii) Japanese Candlestick Chat: Like Bar chart this chart also shows the same information
i.e. Opening, Closing, Highest and Lowest prices of any stock on any day but this chart more
visualizes the trend as change in the opening and closing prices is indicated by the color of the
candlestick.
While Black candlestick indicates closing price is lower than the opening price the white
candlestick indicates its opposite i.e. closing price is higher than the opening price. Another
possibility of no change in opening and closing prices or very near is shown by ‘Doji Candlestick’.
Thus, a white Candlestick indicates a Bullish trend and a black Candlestick indica tes a bearish
trend.
The lowest and highest prices are indicated by vertical bar and opening and closing prices are
shown in the form of rectangular (as per above-mentioned color scheme) placed in between this
bar. In case of Doji Candlestick it is indicated by a simple bar.
Continuing the above example of A Ltd. the prices of share of A Ltd. as per Candlestick chart is
shown below:
(iv) Point and Figure Chart: Point and Figure charts are more complex than line or bar charts.
They are used to detect reversals in a trend. For plotting a point and figure chart, we have to first
decide the box size and the reversal criterion. The box size is the value of each box on the chart,
for example each box could be Re.1, ` 2 or ` 0.50. The smaller the box size, the more sensitive
would the chart be to price change. The reversal criterion is the number of boxes required to be
retraced to record prices in the next column in the opposite direction.
Period Price
1 24 30
2 26 29
3 27 28 X
4 26 27 X
5 28
26 X
6 27
25 X O
7 26
24 X O
8 25
23 O
9 26
22
10 23
2.6 Market Indicators

(i) Breadth Index: It is an index that covers all securities traded. It is computed by dividing the
net advances or declines in the market by the number of issues traded. The breadth index either
supports or contradicts the movement of the Dow Jones Averages. If it supports the movement of
the Dow Jones Averages, this is considered sign of technical strength and if it does not support the
averages, it is a sign of technical weakness i.e. a sign that the market will move in a direction
opposite to the Dow Jones Averages. The breadth index is an addition to the Dow Theory and the
movement of the Dow Jones Averages.
(ii) Volume of Transactions: The volume of shares traded in the market provides useful clues
on how the market would behave in the near future. A rising index/price with increasing volume
would signal buy behaviour because the situation reflects an unsatisfied demand in the market.
Similarly, a falling market with increasing volume signals a bear market and the prices would be
expected to fall further. A rising market with decreasing volume indicates a bull market while a
falling market with dwindling volume indicates a bear market. Thus, the volume concept is best
used with another market indicator, such as the Dow Theory.
(iii) Confidence Index: It is supposed to reveal how willing the investors are to take a chance
in the market. It is the ratio of high-grade bond yields to low-grade bond yields. It is used by
market analysts as a method of trading or timing the purchase and sale of stock, and also, as a
forecasting device to determine the turning points of the market. A rising confidence index is
expected to precede a rising stock market, and a fall in the index is expected to precede a drop in
stock prices. A fall in the confidence index represents the fact that low-grade bond yields are rising
faster or falling more slowly than high grade yields. The confidence index is usually, but not always
a leading indicator of the market. Therefore, it should be used in conjunction with other market
indicators.
(iv) Relative Strength Analysis: The relative strength concept suggests that the prices of
some securities rise relatively faster in a bull market or decline more slowly in a bear market than
other securities i.e. some securities exhibit relative strength. Investors will earn higher returns by
investing in securities which have demonstrated relative strength in the past because the relative
strength of a security tends to remain undiminished over time.
Relative strength can be measured in several ways. Calculating rates of return and classifying
those securities with historically high average returns as securities with high relative strength is
one of them. Even ratios like security relative to its industry and security relative to the entire
market can also be used to detect relative strength in a security or an industry.
(v) Odd - Lot Theory: This theory is a contrary - opinion theory. It assumes that the average
person is usually wrong and that a wise course of action is to pursue strategies contrary to popul ar
opinion. The odd-lot theory is used primarily to predict tops in bull markets, but also to predict
reversals in individual securities.
2.7 Support and Resistance Levels
When the index/price goes down from a peak, the peak becomes the resistance level. When the
index/price rebounds after reaching a trough subsequently, the lowest value reached becomes the
support level. The price is then expected to move between these two levels. Whenever the price
approaches the resistance level, there is a selling pressure because all investors who failed to sell
at the high would be keen to liquidate, while whenever the price approaches the support level,
there is a buying pressure as all those investors who failed to buy at the lowest price would like to
purchase the share. A breach of these levels indicates a distinct departure from status quo, and an
attempt to set newer levels. Let us get a better understanding about these levels by using price
data for about two months for shares of companies A and B given in the f ollowing Table:
Date A B
Dec. 1, 2005 177 177

5 171 171.50
7 172 175.50
12 174 177
13 177.50 181
14 181 184
15 180 186.50
18 163 176
19 142 162.50
20 127 156
22 123 147
25 124 147
Jan. 3, 2006 107.50 137.50
4 97.50 140
8 105 145
10 102.50 143.75
12 108.75 150
15 100 142.50
25 95 135
26 91.25 133.75
Feb. 1 97.50 138.75
2 106.25 147.50
5 113.75 152.50
6 120 155
7 120 152.50
8 113.75 150
9 113.75 147.50
The line charts for Company A and Company B shares are shown in the graph below. From the
charts, it appears that the support level and resistance level for Company A at that time were
about ` 100 and ` 125, while these levels for Company B were ` 140 and ` 160.
2.8 Interpreting Price Patterns

There are numerous price patterns documented by technical analysts but only a few and important
of them have been discussed here:
(a) Channel: A series of uniformly changing tops and bottoms gives rise to a channel
formation. A downward sloping channel would indicate declining prices and an upward sloping
channel would imply rising prices.
(b) Wedge: A wedge is formed when the tops (resistance levels) and bottoms (support levels)
change in opposite direction (that is, if the tops, are decreasing then the bottoms are increasing
and vice versa), or when they are changing in the same direction at different rates over time.
(c) Head and Shoulders: It is a distorted drawing of a human form, with a large lump (for
head) in the middle of two smaller humps (for shoulders). This is perhaps the single most
important pattern to indicate a reversal of price trend. The neckline of the pattern is formed by
joining points where the head and the shoulders meet. The price movement after the formation of
the second shoulder is crucial. If the price goes below the neckline, then a drop in price is
indicated, with the drop expected to be equal to the distance between the top of the head and the
neckline.
(i) Head and Shoulder Top Pattern: This has a left shoulder, a head and a right shoulder. Such
formation represents bearish development. If the price falls below the neck line (line drawn
tangentially to the left and right shoulders) a price decline is expected. Hence it’s a signal to
sell.
(ii) Inverse Head and Shoulder Pattern: As the name indicates this formation, it is an inverse of
head and shoulder top formation. Hence it reflects a bullish development. The price rise to
above the neck line suggests price rise is imminent and a signal to purchase.
HEAD & SHOULDERS INVERSE HEAD & SHOULDERS

(d) Triangle or Coil Formation: This formation represents a pattern of uncertainty and is
difficult to predict which way the price will break out.
(e) Flags and Pennants Form: This form signifies a phase after which the previous price trend
is likely to continue.
TRIANGLE OR COIL FLAG & PENNANT

(f) Double Top Form:This form represents a bearish development, signals that price is
expected to fall.
(g) Double Bottom Form: This form represents bullish development signaling price is
expected to rise.
DOUBLE TOP DOUBLE BOTTOM

(h) Gap: A gap is the difference between the opening price on a trading day and the closing
price of the previous trading day. The wider the gap the stronger the signal for a continuation of
the observed trend. On a rising market, if the opening price is considerably higher than the
previous closing price, it indicates that investors are willing to pay a much higher p rice to acquire
the scrip. Similarly, a gap in a falling market is an indicator of extreme selling pressure.
2.9 Decision Using Data Analysis

Technical analysts have developed rules based on simple statistical analysis of price data. Moving
Averages is one of the more popular methods of data analysis for decision making.
(a) Moving Averages: Moving averages are frequently plotted with prices to make buy and sell
decisions. The two types of moving averages used by chartists are the Arithmetic Moving Averag e
(AMA) and the Exponential Moving Average (EMA). An n-period AMA, at period t, is nothing but
the simple average of the last n period prices.
AMAn,t = 1/n[Pt + Pt-1+ … + Pt-(n-1)]
To identify trend, technical analysts use moving average analysis:
(i) A 200 day’s moving average of daily prices or a 30 week moving of weekly price for
identifying a long term trend.
(ii) A 60 day’s moving average of daily price to discern an intermediate term trend.
(iii) A 10 day’s moving average of daily price to detect a short term trend.
For example Moving Average is calculated by considering the most recent observation for which
the closing price of a stock on ‘10’ successive trading days are taken into account for the
calculation of a 5 -day moving average of daily closing prices.
Trading day Closing prices Sum of 5 most Two-item Moving Average

recent closing
Centered Total
price
1 25.00
2 26.00
3 25.50
4 24.50
5 26.00 127.00
6 26.00 128.00 255.00 25.50
7 26.50 128.50 256.50 25.65
8 26.50 129.50 258.00 25.80
9 26.00 131.00 260.50 26.05
10 27.00 132.00 263.00 26.30
Buy and Sell Signals Provided by Moving Average Analysis

Buy Signal Sell Signal
(a) Stock price line rise through the (a) Stock price line falls through moving
moving average line when graph of average line when graph of the
the moving average line is flattering moving average line is flattering out.
out.
(b) Stock price line rises above moving
(b) Stock price line falls below moving average line which is falling.
average line which is rising.
(c) Stock price line which is slow moving
(c) Stock price line which is above average line rises but begins to fall
moving average line falls but begins again before reaching the moving
to rise again before reaching the average line.
moving average line
(b) Exponential Moving Average: Unlike the AMA, which assigns equal weight of 1/n to each
of the n prices used for computing the average, the Exponential Moving Average (EMA) assigns
decreasing weights, with the highest weight being assigned to the latest price. The weights
decrease exponentially, according to a scheme specified by the exponential smoothing constant,
also known as the exponent, a.
EMAt = aPt + (1-a)(EMAt-1)
2
Where, a (exponent) =
n+ 1
Pt = Price of today
EMAt-1 = Previous day’s EMA
Or
EMAt = (Closing Price of the day – EMA of Previous Day) x Exponent + Previous day EMA
n = Number of days for which average is to be calculated.
2.10 Evaluation of Technical Analysis
Technical Analysis has several supporters as well several critics. The advocates of technical
analysis offer the following interrelated argument in their favour:
(a) Under influence of crowd psychology trend persist for some time. Tools of technical
analysis help in identifying these trends early and help in investment decision making.
(b) Shift in demand and supply are gradual rather then instantaneous. Technical analysis helps
in detecting this shift rather early and hence provides clues to future price movements.
(c) Fundamental information about a company is observed and assimilated by the market over
a period of time. Hence price movement tends to continue more or less in same direction till
the information is fully assimilated in the stock price.
Detractors of technical analysis believe that it is an useless exercise; their arguments are as
follows:
(a) Most technical analysts are not able to offer a convincing explanation for the tools employed
by them.
(b) Empirical evidence in support of random walk hypothesis cast its shadow over the useful
ness of technical analysis.
(c) By the time an up trend and down trend may have been signalled by technical analysis it
may already have taken place.
(d) Ultimately technical analysis must be self defeating proposition. With more and more people
employing it, the value of such analysis tends to decline.
In a nutshell, it may be concluded that in a rational, well ordered and efficient market, technical
analysis may not work very well. However, with imperfection, inefficiency and irrationalities that
characterizes the real world market, technical analysis may be helpful. If technic al analysis is used
in conjunction with fundamental analysis, it might be useful in providing proper guidance to
investment decision makers.
3. DIFFERENCES BETWEEN FUNDAMENTAL ANALYSIS

AND TECHNICAL ANALYSIS
Although a successful investor uses both Fundamental and Technical Analysis but following are
some major differences between them:
S. No. Basis Fundamental Analysis Technical Analysis

1 Method Prospects are measured by analyzing Predicts future prices and their
economy’s macro factors such as direction using purely historical
Country’s GDP, Inflation Rate, market data and information such as
Interest Rate, Growth Rate etc. and their Price Movements, Volume,
company’s micro factors like its Open Interest etc.
Sales, Profitability, Solvency, Asset &
Liabilities and Cash position etc.
2 Rule Prices of a share discounts Price captures everything
everything.
3 Usefulness For Long-Term Investing For Short-term Investing
4. EFFICIENT MARKET THEORY (EFFICIENT MARKET

HYPOTHESIS)
Efficient Market Theory was developed by University of Chicago professor Eugen Fama in the
1960s. As per this theory, at any given time, all available price sensitive information is fully
reflected in securities' prices. Thus, this theory implies that no investor can consistently outperform
the market as every stock is appropriately priced based on available information.
Stating otherwise theory states that no one can "beat the market" hence making it impossible for
investors to either purchase undervalued stocks or sell stocks for inflated prices as stocks are
always traded at their fair value on stock exchanges. Hence it is impossible to outperform the
overall market through expert stock selection or market timing and that the only way an investor
can possibly obtain higher returns is by purchasing risky investments.
4.1 Search for Theory
When empirical evidence in favour of Random walk hypothesis seemed overwhelming,
researchers wanted to know about the Economic processes that produced a Random walk. They
concluded that randomness of stock price was a result of efficient market that led to the following
view points:
• Information is freely and instantaneously available to all market participants.
• Keen competition among the market participants more or less ensures that market will reflect
intrinsic values. This means that they will fully impound all available information.
• Price change only response to new information that is unrelated to previous information and
therefore unpredictable.
4.2 Misconception about Efficient Market Theory
Efficient Market Theory implies that market prices factor in all available information and as such it
is not possible for any investor to earn consistent long term returns from market operations.
Although price tends to fluctuate they cannot reflect fair value. This is because the future is
uncertain. The market springs surprises continually and as prices reflect the surprises they
fluctuate.
Inability of institutional portfolio managers to achieve superior investment performance implies that
they lack competence in an efficient market. It is not possible to achieve superior investment
performance since market efficiency exists due to portfolio mangers doing this job well in a
competitive setting.
The random movement of stock prices suggests that stock market is irrational. Randomness and
irrationality are two different things, if investors are rational and competitive, price changes are
bound to be random.
4.3 Level of Market Efficiency

That price reflects all available information, the highest order of market efficiency. According to
FAMA, there exist three levels of market efficiency:-
(i) Weak form efficiency – Price reflect all information found in the record of past prices and
volumes.
(ii) Semi – Strong efficiency – Price reflect not only all information found in the record of past prices
and volumes but also all other publicly available information.
(iii) Strong form efficiency – Price reflect all available information public as well as private.
4.4 Empirical Evidence on Weak form of Efficient Market Theory
According to the Weak form Efficient Market Theory current price of a stock reflect all information
found in the record of past prices and volumes. This means that there is no relationship between
the past and future price movements.
Three types of tests have been employed to empirically verify the weak form of Efficient Market
Theory- Serial Correlation Test, Run Test and Filter Rule Test.
(a) Serial Correlation Test: To test for randomness in stock price changes, one has to look at
serial correlation. For this purpose, price change in one period has to be correlated with price
change in some other period. Price changes are considered to be serially independent. Serial
correlation studies employing different stocks, different time lags and different time period have
been conducted to detect serial correlation but no significant serial correlation could be
discovered. These studies were carried on short term trends viz. daily, weekly, fortnightly and
monthly and not in long term trends in stock prices as in such cases. Stock prices tend to mo ve
upwards.
(b) Run Test: Given a series of stock price changes each price change is designated + if it
represents an increase and – if it represents a decrease. The resulting series may be -,+, - , -, - ,
+, +.
A run occurs when there is no difference between the sign of two changes. When the sign of
change differs, the run ends and new run begins.
+ + −−− + − + −− + + −−− + − + −−
/ / / / / / / / / /
1 2 3 4 5 6 1 2 3 4 5 6
To test a series of price change for independence, the number of runs in that series is compare d
with a number of runs in a purely random series of the size and in the process determines whether
it is statistically different. By and large, the result of these studies strongly supports the Random
Walk Model.
(c) Filter Rules Test: If the price of stock increases by at least N% buy and hold it until its price
decreases by at least N% from a subsequent high. When the price decreases at least N% or more,
sell it. If the behaviour of stock price changes is random, filter rules should not apply in such a buy
and hold strategy. By and large, studies suggest that filter rules do not out perform a single buy
and hold strategy particular after considering commission on transaction.
4.5 Empirical Evidence on Semi-strong Efficient Market Theory
Semi-strong form efficient market theory holds that stock prices adjust rapidly to all publicly
available information. By using publicly available information, investors will not be able to earn
above normal rates of return after considering the risk factor. To test sem i-strong form efficient
market theory, a number of studies was conducted which lead to the following queries: Whether it
was possible to earn on the above normal rate of return after adjustment for risk, using only
publicly available information and how rapidly prices adjust to public announcement with regard to
earnings, dividends, mergers, acquisitions, stock-splits?
Several studies support the Semi-strong form Efficient Market Theory. Fama, Fisher, Jensen and
Roll in their adjustment of stock prices to new information examined the effect of stock split on
return of 940 stock splits in New York Stock Exchange during the period 1957 -1959 They found
that prior to the split, stock earns higher returns than predicted by any market model.
Boll and Brown in an empirical evaluation of accounting income numbers studied the effect of
annual earnings announcements. They divided the firms into two groups. First group consist s of
firms whose earnings increased in relation to the average corporate earnings while secon d group
consists of firms whose earnings decreased in relation to the average corporate earnings. They
found that before the announcement of earnings, stock in the first group earned positive abnormal
returns while stock in the second group earned negative abnormal returns after the announcement
of earnings. Stock in both the groups earned normal returns.
There have been studies which have been empirically documented showing the following
inefficiencies and anomalies:
• Stock price adjust gradually not rapidly to announcements of unanticipated changes in quarterly
earnings.
• Small firms’ portfolio seemed to outperform large firms’ portfolio.
• Low price earning multiple stock tend to outperform large price earning multiple stock.
• Monday’s return is lower than return for the other days of the week.
4.6 Empirical Evidence on Strong form of Efficient Market Theory
According to the Efficient Market Theory, all available information, public or private, is reflected in
the stock prices. This represents an extreme hypothesis.
To test this theory, the researcher analysed returns earned by certain groups viz. corporate
insiders, specialists on stock exchanges, mutual fund managers who have access to internal
information (not publicly available), or posses greater resource or ability to intensively analyse
information in the public domain. They suggested that corporate insiders (having access to internal
information) and stock exchange specialists (having monopolistic exposure) earn superior rate of
return after adjustment of risk.
Mutual Fund managers do not on an average earn a superior rate of return. No scientific evidence
has been formulated to indicate that investment performance of professionally managed portfolios
as a group has been any better than that of randomly selected portfolios. This was the finding of
Burton Malkiel in his Random Walk Down Wall Street, New York.
4.7 Challenges to the Efficient Market Theory
(a) Information inadequacy – Information is neither freely available nor rapidly transmitted to
all participants in the stock market. There is a calculated attempt by many companies to circulate
misinformation.
(b) Limited information processing capabilities – Human information processing capabilities
are sharply limited. According to Herbert Simon every human organism lives in an environment
which generates millions of new bits of information every second but the bottle necks of the
perceptual apparatus does not admit more than thousand bits per seconds and possibly much
less.
David Dreman maintained that under conditions of anxiety and uncertainty, with a vast interacting
information grid, the market can become a giant.
(c) Irrational Behaviour – It is generally believed that investors’ rationality will ensure a close
correspondence between market prices and intrinsic values. But in practice this is not true. J. M.
Keynes argued that all sorts of consideration enter into the market valuation which is in no w ay
relevant to the prospective yield. This was confirmed by L. C. Gupta who found that the market
evaluation processes work haphazardly almost like a blind man firing a gun. The market seems to
function largely on hit or miss tactics rather than on the basis of informed beliefs about the long
term prospects of individual enterprises.
(d) Monopolistic Influence – A market is regarded as highly competitive. No single buyer or
seller is supposed to have undue influence over prices. In practice, powerful instit utions and big
operators wield grate influence over the market. The monopolistic power enjoyed by them
diminishes the competitiveness of the market.
TEST YOUR KNOWLEDGE

1. Explain the Efficient Market Theory in and what are major misconceptions about this
theory?
2. Explain Dow Jones theory.
3. Explain the Elliot Theory of technical analysis.
4. Explain the various indicators that can be used to assess the performance of an economy.
Practical Questions
1. Closing values of NSE Nifty from 6th to 17th day of the month of January of the year 2020
were as follows:
Days Date Day Sensex

1 6 THU 14522
2 7 FRI 14925
3 8 SAT No Trading
4 9 SUN No Trading
5 10 MON 15222
6 11 TUE 16000
7 12 WED 16400
8 13 THU 17000
9 14 FRI No Trading
10 15 SAT No Trading
11 16 SUN No Trading
12 17 MON 18000
Calculate Exponential Moving Average (EMA) of Sensex during the above period. The
previous day exponential moving average of Sensex can be assumed as 15,000. The value
of exponent for 31 days EMA is 0.062.
Give detailed analysis on the basis of your calculations.
2. The closing value of a Stock Market Index for the month of October, 2007 is given below:
Date Closing Index Value
1.10.07 2800
3.10.07 2780
4.10.07 2795
5.10.07 2830
8.10.07 2760
9.10.07 2790
10.10.07 2880
11.10.07 2960
12.10.07 2990
15.10.07 3200
16.10.07 3300
17.10.07 3450
19.10.07 3360
22.10.07 3290
23.10.07 3360
24.10.07 3340
25.10.07 3290
29.10.07 3240
30.10.07 3140
31.10.07 3260
You are required to test the weak form of efficient market hypothesis by applying the run test at
5% and 10% level of significance.
Following values can be used:
Value of t at 5% is 2.101 at 18 degrees of freedom
Value of t at 10% is 1.734 at 18 degrees of freedom
2. Please refer paragraph 2.4.1

1.
Date 1 2 3 4 5
Sensex EMA for EMA
Previous 1-2 3×0.062 2+4
day
6 14522 15000 (478) (29.636) 14970.364
7 14925 14970.364 (45.364) (2.812) 14967.55
10 15222 14967.55 254.45 15.776 14983.32
11 16000 14983.32 1016.68 63.034 15046.354
12 16400 15046.354 1353.646 83.926 15130.28
13 17000 15130.28 1869.72 115.922 15246.202
17 18000 15246.202 2753.798 170.735 15416.937
Conclusion – The market is bullish. The market is likely to remain bullish for short term to
medium term if other factors remain the same. On the basis of this indicator (EMA) the
investors/brokers can take long position.
2.
Date Closing Index Sign of Price Charge
1.10.07 2800
3.10.07 2780 -
4.10.07 2795 +
5.10.07 2830 +
8.10.07 2760 -
9.10.07 2790 +
10.10.07 2880 +
11.10.07 2960 +
12.10.07 2990 +
15.10.07 3200 +
16.10.07 3300 +
17.10.07 3450 +
19.10.07 3360 -
22.10.07 3290 -
23.10.07 3360 +
24.10.07 3340 -
25.10.07 3290 -
29.10.07 3240 -
30.10.07 3140 -
31.10.07 3260 +
Total of sign of price changes (r) = 8

No of Positive changes = n 1 = 11
No. of Negative changes = n 2 = 8
2n1n2
r= +1
n1 + n2
2  11 8
 = + 1 = 176/19 + 1 = 10.26
11 + 8

2n1n2 (2n1n2 − n1 − n2 )
 =
r (n1 + n2 )2 (n1 + n2 − 1)

 = (2  11 8) (22 11 8 − 11 − 8) = 176 2 157 = 4.252 = 2.06
r (11 + 8) (11 + 8 − 1) (19) (18)
Since too few runs in the case would indicate that the movement of prices is not random.
We employ a two- tailed test the randomness of prices.
Test at 5% level of significance at 18 degrees of freedom using t- table
The lower limit

=  – t ×  =10.26 – 2.101 × 2.06 = 5.932
r
Upper limit

=  + t ×  =10.26 + 2.101 × 2.06 = 14.588
r
At 10% level of significance at 18 degrees of freedom

Lower limit
= 10.26 – 1.734 × 2.06 = 6.688
Upper limit
= 10.26 + 1.734 × 2.06 = 13.832
As seen r lies between these limits. Hence, the market exhibits weak form of efficiency .
*For a sample of size n, the t distribution will have n-1 degrees of freedom.
4
SECURITY VALUATION
LEARNING OUTCOMES
After reading this chapter student shall be able to understand:
❑ Overview of Valuation
❑ Return Concepts
❑ Equity Risk Premium
❑ Required Return on Equity
❑ Discount Rate Selection in Relation to Cash Flows
❑ Valuation of Equity Shares
❑ Valuation of Preference Shares
❑ Valuation of Debentures/ Bonds
1. OVERVIEW OF VALUATION
The definition of an Investment is – Investment involves commitment of funds with an objective to
obtain a return that would pay off the investor for the time during which the funds are invested or
locked, for the expected rate of inflation over the investment horizon, and for the risk involved.
Most investments are expected to have future cash flows and a stated market price (e.g., price of a
common stock), and one must estimate a value for the investment to determine if its current
market price is consistent with his estimated intrinsic value. Investment returns can take many
forms, including earnings, cash flows, dividends, interest payments, interest on interest payments
or capital gains (increases in value) during an investment horizon.
Knowing what an asset is worth and what determines its value is a pre-requisite for making
intelligent investment decisions while choosing investments for a portfolio or in deciding an
appropriate price to pay or receive in a business takeover and in making investment, financing and
dividend choices when running a business. We can make reasonable estimates of value for most
assets, and that the fundamental principles determining the values of all types of assets whether
real or financial, are the same. While some assets are easier to be valued than others, for different
assets, the details of valuation and the uncertainty associated with their value estimates may vary.
However, the core principles of valuation always remain the same.
2. RETURN CONCEPTS
A sound investment decision depends on the correct use and evaluation of the rate of return.
Some of the different concepts of return are given as below:
2.1 Required Rate of Return
Required rate of return is the minimum rate of return that the investor i s expected to receive while
making an investment in an asset over a specified period of time. This is also called Opportunity
Cost or Cost of Capital because it is the highest level of expected return forgone which is available
elsewhere from investment of similar risks. Many times required rate of return and expected return
are used interchangeably.
2.2 Discount Rate
Discount Rate is the rate used to calculate present value of future cash flows Discount rate
depends on the risk-free rate and risk premium of an investment. Actually, each cash flow stream
coming from different assets can be discounted at a different discount rate. This is because of
variation in risk premium which may be due to expected inflation rate, different maturity levels and
probability of defaults. This can be explained with the help of term structure of interest rates. For
instance, in upward sloping term structure of interest rates, interest rates increase with the
maturity as longer maturity may mean more inflation risk, more liquidity risk or more default risk.
Though future cash flows can be discounted at different discount rate, one may use the same
discount rate to get the same present value of a stream of cash flows. When a single discount rate
is applied instead of many discount rates, many individual discount rates can be replaced with an
equivalent single discount rate which eventually gives the same present value.
Example: Cash flows and discount rates for each year of cash flows at different maturities have
been given as below:-
SECURITY VALUATION 4.3
1st year 2nd year 3rd year 4th year 5th year
Cash flows `100 `200 `300 `400 `500
Discount rates 2.0% 3.2% 3.6% 4.8% 5.0%
The present value of this stream of cash flows, by discounting each cash flow with the respective
discount rate, is ` 1,278.99.
The single discount rate equates the present value of the stream of cash flows to approximately
`1278.99 at 4.4861% (any difference is due to rounding).
2.3 Internal Rate of Return
Internal Rate of Return is defined as that discount rate which equates the present value of future
cash flows of a security to its market price. The IRR is viewed as the average annual rate of return
that investors earn over their investment time period assuming that the cash flows are reinvested
at the IRR. This can be explained with the help of an example as follows:
Example
Suppose you are recommended to invest ` 20,000 now in an asset that offers a cash flow ` 3,000
one year from now and ` 23,000 two years from now. You want to estimate the IRR of the
investment. For this purpose you must find the discount rate that equates the present value of
cash inflows to ` 20,000, the value of the initial investment.
Time 0 1st year 2nd year

Cash flows ` 20,000 ` 3,000 ` 23,000
We solve the following equation for r which denotes IRR and get 15%.
20000 = 3000/(1+r) + 23000/(1+r) 2
=> r = 15%
Thus, our IRR is 15%, which implies that we earn on an average 15% on the investment per
annum. Now let’s assume that when we receive ` 3,000, we reinvest it at 10% for one year and
after one year we receive total ` 26,300, ` 3,300 of which is attributable to reinvestment of `
3,000. Since we receive total cash `26300 we can estimate the IRR of the investment.
(26300/20000) 1/2 – 1 = 0.1467 or 14.67%
Annual return is now at 14.67% if reinvested at 10%, which is actually less than what was
expected to be earned before investment. The reason is that the cash flow was reinvested at a
rate (10%) which is less than our expected IRR (15%).
If we had a chance to reinvest ` 3,000 at 15%, we would receive ` 26,450 at the end of 2 nd year,
and the IRR of the investment would be equal to exactly 15% as calculated below:
(26450/20,000)1/2 – 1 = 0.15 or 15%
3. EQUITY RISK PREMIUM

Equity risk premium is the excess return that an investment in equity shares provides over a risk
free rate, such as return from tax free government bonds. This excess return compensates
investors for taking on the higher risk of investing in equity shares of a company. The size of the
premium will change depending upon the level of risk in a particular portfolio and will also change
over time as market risk fluctuates. Generally, high-risk investments are compensated with a
higher premium.
The equity risk premium is based on the idea of the risk-reward trade-off. However, equity risk
premium is a theoretical concept because it is difficult to predict that how a particular stock or the
stock market as a whole will perform in the future. It can only be estimated by observing stock
market and government bond market over a specified period of time, for instance from 1990 to the
present period. Further, estimates may vary depending on the time frame and method of
calculation.
3.1 Explanation of Equity Risk Premium
Investment in equity shares of a company is a high risk investment. If an investor is investing in
equity shares of a company, he wants some risk premium over the risk free investment avenues
such as government bonds. For example, if an investor could earn a 7% return on a Government
Bond (which is generally considered as risk free investment), a company’s share should earn 7%
return plus an additional return (the equity risk premium) in order to attract the investor.
Equity investors try to achieve a balance between risk and return. If a company wants to pursue
investors to put their money into its stock, it must provide a stimulus in the form of a premium to
attract the equity investors. If the stock gives a 15% return, in the example mentioned in the
previous paragraph, the equity risk premium would be 8% (15% - 7% risk free rate). However,
practically, the price of a stock, including the equity risk premium, moves with the market.
Therefore, the investors use the equity risk premium to look at historical values, risks, and returns
on investments.
3.2 Calculating the Equity Risk Premium
To calculate the equity risk premium, we can use the Capital Asset Pricing Model (CAPM), which is
usually written:
Rx = Rf + βx (Rm - Rf)
Where:
Rx = expected return on equity investment in "x"(company x)
Rf = risk-free rate of return
βx = beta of "x"
Rm = expected return of market
Now, if we assume that x is identical to the Market Index, m, then Rx = Rm. Beta is a measure of a
stock's systematic risk ; and if x = m, then βx = βm = 1. Whereas Rm - Rf is known as the Market
Risk Premium; Rx - Rf is the risk premium of a particular stock. If x is an equity investment,
then Rx - Rf is the equity risk premium; if x = m, then the market premium and the equity risk
premium are the same.
Therefore, the equity risk premium can be calculated as follows:
Equity Risk Premium = R x - Rf = βx (Rm - Rf)
4. REQUIRED RETURN ON EQUITY

If equity risk premium is calculated as indicated above, required rate of return can be easily
calculated with the help of Capital Asset Pricing Model (CAPM). The main insight of the model is
that the investors evaluate the risk of an asset in terms of the asset’s contribution to the systematic
risk (cannot be reduced by portfolio diversification) of their total portfolio. CAPM model provides a
relatively objective procedure for required return estimation; it has been widely used in valuation.
So, the required return on the share of particular company can be computed as below:
Return on share ‘A’ = Risk free return + β x Market Risk Premium
Example:
Risk free rate 5%,
β 1.5
and, Market risk premium 4.5%
Calculate Required return on equity.
Solution
Required return on share A = Risk free return + β x Market Risk Premium
= 0.05 + 1.5 (0.045)
= 0.1175 or 11.75%
5. DISCOUNT RATE SELECTION IN RELATION TO CASH

FLOWS
Cash flows are discounted at a suitable rate to arrive at the present value of future cash flows.
Cash flows are required by any organization to settle their debt claims and taxes. Whatever
amount remains are the cash flows available to equity shareholders. When cashflows to be
available to equity shareholders are discounted, the required rate of return on equity is an
appropriate discount rate. Further, when cash flows are available to meet the claims of all of
company’s stakeholders, then the cost of capital is the appropriate discount rate.
5.1 Concept of Nominal Cash Flow and Real Cash Flow

Nominal cash flow is the amount of future revenues the company expects to receive and expenses
it expects to pay out, without any adjustments for inflation. For instance, a company which wants
to invest in a utility plant wants to forecast its future revenues and expenses it has to incur while
earning its income (i.e. wages to labour, electricity, water, gas pipeline etc.).
On the other hand, Real cash flow shows a company's cash flow with adjustments for inflation.
Since inflation reduces the spending power of money over time, the real cash flow shows the
effects of inflation on a company's cash flow.
In the short term and under conditions of low inflation, the nominal and real cash flows are almost
same. However, in conditions of high inflation rates, the nominal cash flows will be higher than the
real cash flows.
5.2 Discount rate selection in Equity Valuation
From the above discussion, it can be concluded that cash flows can be nominal or real. When cash
flows are stated in real terms, then they are adjusted for inflation. However, in case of nominal
cash flow, inflation is not adjusted.
For nominal cash flow, nominal rate of discount is used and for real cash flow, real rate of discount
is used. While valuing equity shares, only nominal cash flows are considered. Therefore, only
nominal discount rate is considered. The reason is that the tax applying to corporate earnings is
generally stated in nominal terms. Therefore, using nominal cash flow in equity valuation is the
right approach because it reflects taxes accurately.
Moreover, when the cash flows are available to equity shareholders only, nominal discount rate
applicable in case of equity is used. And, the nominal after tax weighted average cost of capital is
used when the cash flows are available to all the company’s capital providers.
6. VALUATION OF EQUITY SHARES

In order to undertake equity valuations, an analyst can use different approaches, some of which
are classified as follows:
(1) Dividend Based Models
(2) Earning Based Models
(3) Cash Flows Based Model
6.1 Dividend Based Models
As we know that dividend is the reward for the provider of equity capital, the same can be used to
value equity shares. Valuation of equity shares based on dividend are based on the following
assumptions:
a. Dividend to be paid annually.

b. Payment of first dividend shall occur at the end of first year.
c. Sale of equity shares occur at the end of a year and that to at ex-dividend price.
The value of any asset depends on the discounted value of cash streams expected from the same
asset. Accordingly, the value of equity shares can be determined on the basis of stream of
dividend expected at Required Rate of Return or Opportunity Cost i.e. Ke (Cost of Equity).
Value of equity share can be determined based on holding period as follows:
(1) Valuation Based holding period of One Year : If an investor holds the share for one year
then the value of equity share is computed as follows:
D1 P1 D+P
P0 = 1
+ 1
= 1 11
(1 + K e ) (1 + K e ) (1 + K e )
Example: Share of X Ltd. is expected to be sold at ` 36 with a dividend of ` 6 after one year. If
required rate of return is 20% then what will be the share price?
Answer
The expected share price shall be computed as follows:
6 36
P0 = + = ` 35
(1+0.20) (1+0.20)1
1
(2) Valuation Based on Multi Holding Period: In this type of holding following three types of
dividend pattern can be analyzed.
(i) Zero Growth: Also, called as No Growth Model, as dividend amount remains same over the
years infinitely. The value of equity can be found as follows:
D
P0=
(K e )
(ii) Constant Growth: Constant Dividend assumption is quite unrealistic assumption.
Accordingly, one very common model used is based on Constant Growth in dividend for infinitely
long period. In such situation, the value of equity shares can be found by using following formula:
D1 D0(1+g)
P0= or
Ke - g (K e - g)
It is important to observe that the above formula is based on Gordon Growth Model of Calculation
of Cost of Equity.
(iii) Variable Growth in Dividend: Just like no growth in dividend assumption, the constant
growth assumption also appears to be unrealistic. Accordingly, valuation of equity shares can be
done on the basis of variable growth in dividends. It should however be noted that though we can
assume multiple growth rates but one growth rate should be assumed for infinity, only then we can
find value of equity shares.
Although stages of Company’s growth fall into following categories such as Growth, Transition and
Maturity Phase but for Valuation the multiple dividend growth can be divided into following two
categories.
(a) Two Stage Dividend Discount Model: While simple two stage model assumes extraordinary
growth (or supernormal growth) shall continue for finite number of years, the normal growth shall
prevail for infinite period. Accordingly, the formula for computation of Share Price or equity value
shall be as follows:
 D0(1+g1) D0(1+g1)2 D0(1+g1)n  Pn
P0 =  1
+ 2
...........+ n 
+
 (1+K e ) (1+K e ) (1+K e )  (1+K e )n
D0 (1+g1)n (1+g2)
Pn =
(K e - g2)
Where, D0 = Dividend Just Paid
g1 = Finite or Super Growth Rate
g2 = Normal Growth Rate
Ke = Required Rate of Return on Equity
Pn = Price of share at the end of Super Growth i.e. beginning of Normal Growth Period
(b) Three Stage Dividend Discount Model: As per one version there are three phases for
valuations: extraordinary growth period, transition period and stable growth period.
In the initial phase, a firm grows at an extraordinarily high rate, after which its advantage gets
depleted due to competition leading to a gradual decline in its growth rate. This phase is the
transition phase, which is followed by the phase of a stable growth rate.
Accordingly, the value of equity share shall be computed, as in case of two stage growth mode l by
adding discounted value of Dividends for two growth periods and finally discounted value of share
price at the beginning of sustainable or stable growth period.
There is another version of three stage growth model called H Model. In the first stage dividend
grows at high growth rate for a constant period, then in second stage it declines for some constant
period and finally grow at sustainable growth rate.
H Model is based on the assumption that before extraordinary growth rate reach to normal growth
it declines lineally for period 2H.
Though the situation is complex but the formula for calculation of equity share shall be as follows
which is sum of value on the normal growth rate and premium due to abnormal growth rate:
D0(1 + gn) D0H1(gc - gn)
P0 = +
r - gn r - gn
Where gn= Normal Growth Rate Long Run
gc= Current Growth Rate i.e. initial short term growth rate
H1= Half-life of high growth period
These variants of models can also be applied to Free Cash Flow to Equity Model discussed later.
6.2 Earning Based Models

Above mentioned models are based on Dividends. However, nowadays an investor might be
willing to forego cash dividend in lieu of higher earnings on retained earning ultimately leading to
higher growth in dividend.
Hence, these investors may be interested in determination of value of equity share based on
Earning rather than Dividend. The different models based on earnings are as follows:
(a) Gordon’s Model: This model is based on following broad assumptions:
(i) Return on Retained earnings remains the same.
(ii) Retention Ratio remains the same.
Valuation as per this model shall be
EPS1(1 - b)
K e - br
Where, r = Return on Equity
b = Retention Ratio
(b) Walter’s Approach: This approach is based on Walter Model discussed at Intermediated
Level in the Financial Management Paper. As per this model, the value of equity share shall be:
r
D + (E - D)
Ke
Ke
(c) Price Earning Ratio or Multiplier Approach: This is one of the common valuation approaches
followed. Since, Price Earning (PE) Ration is based on the ratio of Share Price and EPS, with a
given PE Ratio and EPS, the share price or value can simply be determined as follows:
Value = EPS X PE Ratio
Now, the question arises how to estimate the PE Ratio. This ratio can be estimated for a similar
type of company or of industry after making suitable adjustment in light of specific features
pertaining to the company under consideration. It should further be noted that EPS should be of
equity shares. Accordingly, it should be computed after payment of preference dividend as follows:
Profit after tax – Preference Dividend
EPS =
Number of Equity Shares
6.3 Cash Flow Based Models

In the case of Dividend Discounting Valuation model (DDM) the cash flows are dividend which are
to be distributed among equity shareholders. This cash flow does not take into consideration the
cash flows which can be utilised by the business to meet its long-term capital expenditure
requirements and short-term working capital requirement. Hence dividend discount model does not
reflect the true free cash flow available to a firm or the equity shareholders after adjusting for its
capex and working capital requirement.
Free cash flow valuation models discount the cash flows available to a firm and equity
shareholders after meeting its long term and short-term capital requirements. Based on the
perspective from which valuations are done, the free cash flow valuation models are classified as:
• Free Cash Flow to Firm Model (FCFF)
• Free Cash Flow to Equity Model (FCFE)
In the case of FCFF model, the discounting factor is the cost of capital (K o) whereas in the case of
FCFE model the cost of equity (K e) is used as the discounting factor.
FCFE along with DDM is used for valuation of the equity whereas FCFF model is used to find out
the overall value of the firm.
6.3.1 Calculation of Free Cash Flow to Firm (FCFF): FCFF can be calculated as follows:
(a) Based on its Net Income:
FCFF= Net Income + Interest expense *(1-tax) + Depreciation -/+ Capital Expenditure –/+
Change in Non-Cash Net Working Capital
(b) Based on Operating Income or Earnings Before Interest and Tax (EBIT):
FCFF= EBIT *(1 - tax rate) + Depreciation -/+ Capital Expenditure –/+ Change in Non-Cash
Net Working Capital
(c) Based on Earnings before Interest, Tax , Depreciation and Amortisation (EBITDA):
FCFF = EBITDA* (1-Tax) +Depreciation* (Tax Rate) -/+ Capital Expenditure – /+Change in
Non-Cash Net Working Capital
(d) Based on Free Cash Flow to Equity (FCFE):
FCFF = FCFE + Interest* (1-t) + Principal Prepaid – New Debt Issued + Preferred Dividend
(e) Based on Cash Flows:

FCFF = Cash Flow from Operations (CFO) + Interest (1-t) -/+ Capital Expenditure
Capital Expenditure or Capex for a single year is calculated as Purchase of Fixed Asset current
year - Sale of Fixed Asset current year taken from Cash Flow from Investing Activities.
Change in Non- Cash Working Capital is calculated as:
Step 1: Calculate Working Capital for the current year: Working Capital =Current Asset-Current
Liability
Step 2: Calculate Non-Cash Net Working Capital for the current year: Current Assets – Cash and
Bank Balance – Current Liabilities
Step 3: In a similar way calculate Working Capital for the previous year
Step 4: Calculate change in Non-Cash Working Capital as: Non-Cash Working Capital for the
current year- Non-Cash Working Capital for the previous year
Step 5: If change in Non-Cash Working Capital is positive, it means an increase in the working
capital requirement of a firm and hence is reduced to derive at free cash flow to a firm.
Based on the type of model discussed above the value of Firm can be calculated as follows:
(a) For one stage Model: Intrinsic Value = Present Value of Stable Period Free Cash Flows to
Firm
(b) For two stage Model: Intrinsic Value = Present value of Explicit Period Free Cash Flows to
Firm + Present Value of Stable Period Free Cash Flows to a Firm, or
Intrinsic Value = Present Value of Transition Period Free Cash Flows to Firm + Present
Value of Stable Period Free Cash Flows to a Firm
(c) For three stage Model: Intrinsic Value=Present value of Explicit Period Free Cash Flows to
Firm + Present Value of Transition Period Free Cash Flows to Firm + Present Value of
Stable Period Free Cash Flows to Firm
6.3.2 Calculation of Free Cash Flow to Equity (FCFE): Free Cash flow to equity is used for
measuring the intrinsic value of the stock for equity shareholders. The cash that is available for
equity shareholders after meeting all operating expenses, interest, net debt obligations and re -
investment requirements such as working capital and capital expenditure. It is computed as:
Free Cash Flow to Equity (FCFE) = Net Income - Capital Expenditures +Depreciation - Change in
Non-cash Net Working Capital + New Debt Issued - Debt Repayments + Net issue of Preference
Shares – Preference Share Dividends
or
FCFE = Net Profit + depreciation - ∆NWC - CAPEX + New Debt - Debt Repayment + Net issue of
Preference Shares – Preference Share Dividends
∆NWC = changes in Net Working Capital.
CAPEX = Addition in fixed assets to sustain the basis.
FCFE can also be used to value share as per Multistage Growth Model approach.
6.4 Dividend Discount Model versus Free Cash Flow to Equity Model
In the dividend discount model the analyst considers the stream of expected dividends to value the
company’s stock. It is assumed that the company follows a consistent dividend payout ratio which
can be less than the actual cash available with the firm.
Dividend discount model values a stock based on the cash paid to shareholders as dividend.
A stock’s intrinsic value based on the dividend discount model may not represent the fair value for
the shareholders because dividends are distributed in the form of cash from profits. In case the
company is maintaining healthy cash in its balance sheet then it means that dividend pay-outs is
low which could result in undervaluation of the stock.
In the case of free cash flow to equity model a stock is valued on the cash flow available for
distribution after all the reinvestment needs of capex and incremental working capital are met.
Thus using the free cash flow to equity valuation model provides a better measure for valuations in
comparison to the dividend discount model.
6.5 Enterprise Value
Enterprise Value is the true economic value of a company. It is calculated by adding market
capitalization, Long term Debt, Minority Interest minus cash and cash equivalents. (Also Minus like
Equity investments like affiliates, investment in any company and also Long term investments.
Enterprise Value is of three types: Total, Operating and Core EV. Total Enterprise Value is the
value of all the business activities; it is the summation of market capitalization, Debt (Interest
Bearing), Minority Interest “minus “cash. The operating Enterprise value is the value of all
operating activities, and to get this we have to deduct “market value of non- operating assets”
which includes Investments and shares (in associates) from the total enterprise value.
Core enterprise value is the value which does not include the value of operations which are not the
part of activities. To get this we deduct the value of non-core assets from the operating enterprise
value.
Enterprise value measures the business as a whole and gives its true economic value. It is more
comprehensive than equity multiples. Enterprise value considers both equity and debt in its
valuation of the firm and is least affected by its capital structure. Enterprise multiples are more
reliable than equity multiples because Equity multiples focus only on equity claim.
There are different Enterprise Value multiples which can be calculated as per the requirement
(which requirement). If we take the EV as numerator then the denominator must represent the
claims of all the claimholders on enterprise cash flow.
6.5.1 Enterprise Value to Sales: This multiple is suitable for the corporates who maintain
negative cash flows or negative earnings as cyclical firms. Corporate like technological firms
generally use this multiple. Sales are the least manipulative top line for any business and least
affected by accounting policies.
6.5.2 Enterprise Value to EBITDA: EBITDA, which is commonly known as the proxy of cash
flow, is the amount available to debt and equity holders of a company. This multiple is used for
valuing capital intensive companies, which generally have substantial depreciation and
amortization expenses. This multiple is used for acquisitions as it incorporates debts as well equity
of the business. An analyst prefers this multiple because it is not affected by depreciation policy
and changes in capital structure. The inverse of this multiple explains cash return on total
investment.
6.6 Valuation of Rights
As we know that company offers right shares to the existing shareholders. Immediately after the
right issue, the price of share is called Ex Right Price or Theoretical Ex-Right Price (TERP) which
is computed as follows:
nP0 + S
n + n1
n = No. of existing equity shares
P0 = Price of Share Pre-Right Issue
S = Subscription amount raised from Right Issue
n1 = No. of new shares offered
However, theoretical value of a right can be calculated as follows:

P0 - S
P0 - S
Value of Per Shareholding =
n
7. VALUATION OF PREFERENCE SHARES

Preference shares, like debentures, are usually subject to fixed rate of dividend. In case of non -
redeemable preference shares, their valuation is similar to perpetual bonds.
Valuation of Redeemable preference share
The value of redeemable preference share is the present value of all the future expected dividend
payments and the maturity value, discounted at the required return on preference shares.
Therefore, Value of Redeemable Preference Share shall be:
=
Dividend1 Dividend2
+ + ..................+
(Dividendn + Maturity value )
(1+ r ) (1+ r ) (1+ r )
1 2 n
and Value of Non-Redeemable Preference Share shall be:

Dividend
Irredeemable Preference share value =
Required return on Preference share
Example
The face value of the preference share is ` 10,000 and the stated dividend rate is 10%. The
shares are redeemable after 3 years period. Calculate the value of preference shares if the
required rate of return is 12%.
Annual dividend = `10000 x 10% = `1000
Redeemable Preference share value
1,000 1,000 1,000 + 10,000
= + 2
+
(1+ 0.12) (1+ 0.12) (1+ 0.12) 3
1,000 1,000 11,000
= + +
(1.12) (1.12)2 (1.12)3
= 892.86 + 797.19 + 7829.58
= 9519.63
Solving the above equation, we get the value of the preference shares as ` 9519.63
8. VALUATION OF DEBENTURES AND BONDS

8.1 Some Basics of a Bond
(a) Par Value: Value stated on the face of the bond of maturity.
(b) Coupon Rate and Frequency of Payment: A bond carries a specific interest rate known as
the Coupon Rate. The coupon can be paid monthly, quarterly, half-yearly or annually.
(c) Maturity Period: Total time till maturity.
(d) Redemption: Bullet i.e. one shot repayment of principal at par or premium.
8.2 Bond Valuation Model
The value of a bond is:
n
I F
V= t
+
t =1 (1 + k )
d
(1 + k d )n
V = I ( PVIFAkd ,n ) + F ( PVIFkd ,n )
Where,
V = value of the bond
I = annual interest payable on the bond
F = principal amount (par value) of the bond repayable at the time of maturity
n = maturity period of the bond
kd = Yield to Maturity (YTM) or Required Rate of Return on same type of Bonds.
8.3 Bond Value Theorems
Some basic rules, which should be remembered with regard to bonds, are:
CAUSE EFFECT
Required rate of return or YTM = Bond sells at par value
coupon rate
Required rate of return or YTM > Bond sells at a discount
coupon rate
Required rate of return or YTM < Bond sells at a premium
coupon rate
Longer the maturity of a bond Greater the bond price change with a given change
in the required rate of return.
8.4 Yield to Maturity (YTM)

The YTM is defined as that discount rate (“k d”) at which the present value of future cash flows from
a Bond equals its Market Price.
8.5 Bond Value with Semi-Annual Interest
The basic bond valuation equation thus becomes:
I
2n
2 + F
V=  t 2n
t=1  kd   kd 
 1+ 2   1+ 2 
   
= I/2(PVIFAkd/2,2n) + F(PVIF kd/2,2n)
Where,
V = Value of the bond
I/2 = Semi-annual interest payment
Kd/2 = Discount rate applicable to a half-year period
F = Par value of the bond repayable at maturity
2n = Maturity period expressed in terms of half-yearly periods.
8.6 Price Yield Relationship
A basic property of a bond is that its price varies inversely with yield. The reason is - as the
required yield increases, the present value of the cash flow decreases; hence the price decreases
and vice versa.
8.7 Relationship between Bond Price and Time
Since the price of a bond must equal its par value at maturity (assuming that there is no risk of
default), bond prices change with time and they approach to the par value of the bond. It means
that if a bond is trading at premium, its price will decrease over time and if a bond is trading at a
discount, its price will increase over time.
8.8 Duration of Bond
Duration is the weighted average time within which an investor gets back the promised principal
and the promised YTM. Investment coupon bearing bond always has a duration which is lesser
than its maturity. Higher the coupon rate, lesser would be the duration and higher the yield-to-
maturity, lower will be the duration of a bond.
It measures how quickly a bond will repay its true cost. The longer the time it takes the greater
exposure the bond has to changes in the interest rate environment and hence, higher interest rate
risk. Duration is also a measure of interest rate risk – higher duration implies higher interest rate
risk and lower duration means lower interest rate risk. Following are some of factors that affect
bond's duration:
(i) Time to maturity: The shorter-maturity bond would have a lower duration and less interest
rate risk and vice versa.
(ii) Coupon rate: Coupon payment is a key factor in calculation of duration of bonds. The
higher the coupon, the lower is the duration and vice versa.
(iii) Yield-to-Maturity (YTM): Higher yield-to-maturity means lower duration and hence, lower
interest rate risk and vice versa.
Although there are many formulae to calculate the duration. However, following are commonly
used methods:
(a) Macaulay Duration: This formula measures the number of years required to recover the
true cost of a bond, considering the present value of all coupon and principal payments received in
the future. The formula for Macaulay duration is as follows:
n
t*c n*M
 (1+i)
t=1
t
+
(1+i)n
Macaulay Duration =
P
Where,
n = Time to maturity
C = Cash flows (Coupon Amount)
i = Required yield
M = Maturity (par) value
P = Bond price
(b) Modified Duration: This is a modified version of Macaulay duration which takes into
account the interest rate changes because the changes in interest rates affect duration as the yield
gets affected each time the interest rate varies.
The formula for modified duration is as follows:
 
 Macaulay Duration 
Modified Duration =  
  YTM  
 1 +  
  n  
Where
n = Number of compounding periods per year
YTM = Yield to Maturity
8.9 Immunization
We know that when interest rate goes up although reinvestment income improves but value of
bond falls and vice versa. Thus, the interest rate risk of a bond is subject to following two risk:
(a) Price Risk
(b) Reinvestment Risk
Further, with change in interest rates these two risks move in opposite direction. Through the
process of immunization selection of bonds shall be in such manner that the effect of above two
risks shall offset each other. It means that immunization takes place when the changes in the YTM
in market has no effect on the promised rate of return on a bond; that’s a portfolio of bond is said
to be immunized if the value of the portfolio at the end of a holding period is insensitive to interest
rate changes. If the duration of a bond is equal to its holding period, then we ensure immunization
of the same and hence, the bond is not having interest rate risk.
8.10 Yield Curve
The term structure of interest rates, also known as Yield Curve, shows how yield to maturity is
related to term to maturity for bonds that are similar in all respects, except maturity.
Consider the following data for Government securities:
Face Value Coupon Rate (%) Maturity (years) Current Price Yield to Maturity (%)
10,000 12.40 1 9,987 12.546

10,000 12.75 2 9,937 13.128
10,000 13.50 3 10,035 13.351
10,000 13.50 4 9,971 13.599
10,000 13.75 5 9,948 13.901
The yield curve for the above bonds is shown in the diagram. It slopes upwards indicating that
long-term rates are greater than short-term rates.
Yield curves, however, do not have to necessarily slope upwards. They may follow different
pattern. Four patterns are depicted in the given diagram:
Types of Yield Curve
Another perspective on the term structure of interest rates is provided by the forward interest
rates, viz., the interest rates applicable to bonds in the future.
To get forward interest rates, begin with the one-year Zero Coupon Bond:
8,897 = 10,000 / (1 + r1)
Where,
r1 is the one-year spot rate i.e. the discount rate applicable to a risk less cash flow
receivable a year hence.
Solving for r1, we get r1 = 0.124.
Next, consider the two-year government security and split its benefits into two parts, the interest of
` 1,275 receivable at the end of year 1 and ` 11,275 (representing the interest and principal
repayment) receivable at the end of year 2. The present value of the first part is:
11,275 11,275
=
(1+r1 )(1+f2 ) 1.124(1+f2 )
To get the present value of the second year’s cash flow of ` 11,275, discount it twice at r 1 (the
discount rate for year 1) and f2 (the discount rate for year 2) (please use f notation for the forward
rate so as to make a distinction between the spot rate and forward rate)
1,275 1,275
=
(1 + r1 )(1+ rf2 ) 1.124(1+ rf2 )
f2 is called the ‘forward rate’ for after one for next one year i.e., the current expected estimate of
the next year’s one-year spot interest rate. Since r 1, the market price of the bond, and the cash
flow associated with the bond are known the following equation can be set up:
1,275 11,275
9,937 = +
(1.124) (1.124)(I + r2 )
9,937(1.124)(1 + r 2) = 1,275 (1 + r 2) + 11,275

11,169 + 11,169 r 2 = 1,275 + 1,275 r 2 + 11,275
11,169 r 2 – 1,275 r2 = 11,275 – 11,169 + 1,275
9,894 r 2 = 1,381
1,381
r2 = = 0.1396
9,894
Thus solving this equation we get r 2 = 0.1396 say 14%
To get the forward rate for year 3(r 3), set up the equation for the value of the three year bond:
1,350 1,350 11,350
10,035 = + +
(1+ r1 ) (1 + r1 )(1+ r2 ) (1+ r1 )(1+ r2 )(1+ r3 )
1,350 1,350 11,350
10,035 = + +
(1.124) (1.124)(1.140) (1.124)(1.140)(1+ r3 )
1,350 1,350 11,350
10,035 = + +
1.124 1.28136 1.28136(1+ r3 )
11,350
10,035 = 1,201+ 1,054 +
1.28136(1+ r3 )
11,350
7780 =
1.28136(1+r3 )
1 + r3 = 1.13853
r3 = 0.13853
Solving this equation we get r 3=0.13853. This is the forward rate for year three. Continuing in a
similar fashion, set up the equation for the value of the four-year bond:
1,350 1,350 1,350 11,350
9,971 = + + +
(1+ r1 ) (1+ r1 )(1+ r2 ) (1+ r1 )(1+ r2 )(1+ r3 ) (1+ r1)(1+ r2 )(1+ r3 )(1+ r4 )
Solving this equation we get r 4 = 0.1462 (approx.). The following diagram plots the one-year spot
rate and forward rates f2, f3, f4. It can be noted that while the current spot rate and forward rates
are known, the future spot rates are not known – they will be revealed as the future unfolds.
Thus, on the basis of above it can be said that though YTM and Forward Rates are two distinct
measures but used equivalent way of evaluating a riskless cash flows.
CF( t)
Discount at the yield to maturity : (R t ) PV [CF(t)] =
(1+ R t ) t
Discount by the product of a spot rate plus the forward rates
CF( t)
PV [CF(t)] =
(1+ r1 )(1+ r2 )(1+ rt )
8.11 Term Structure Theories

The term structure theories explain the relationship between interest rates or bond yields and
different terms or maturities. The different term structures theories are as follows:
(a) Expectation Theory: As per this theory the long-term interest rates can be used to forecast
short-term interest rates in the future as long-term interest rates are assumed to unbiased
estimator of the short term interest rate in future.
(b) Liquidity Preference Theory: As per this theory investors are risk averse and they want a
premium for taking risk. Long-term bonds have higher interest rate risk because of higher maturity,
hence, long-term interest rates should have a premium for such a risk. Further, people prefers
liquidity and if they are forced to sacrifice the same for a longer period, they need a h igher
compensation for the same. Hence, as per this theory, the normal shape of a yield curve is
Positive sloped one.
(c) Preferred Habitat Theory (Market Segmentation Theory): This theory states that though as
per different investors may be having different preference for shorter and longer maturity periods
and therefore, they have their own preferred habitat. Hence, the interest rate structure depends on
the demand and supply of fund for different maturity periods for different market segments. In case
there is a mismatch between these forces, the players of a particular segment should be
compensated at a higher rate to pull them out from their preferred habitat; hence, that will
determine the shape of the yield curve. Accordingly, shape of yield curve will be determined which
can be sloping upward, falling or flat.
8.12 Convexity Adjustment
As mentioned above duration is a good approximation of the percentage change in price due to
percentage change for a small change in interest rate. However, the change cannot be estimated
so accurately due to convexity effect as duration base estimation assumes a linear relationship.
This estimation can be improved by adjustment to the duration formula on account of ‘convexity’ as
follows:
C* x (∆y)2 x100
V+ + V- - 2V0
C* =
2V0 (Δy)2
∆y = Change in Yield
V0 = Initial Price of bond
V+ = price of Bond if yield increases by ∆y
V- = price of Bond if yield decreases by ∆y
The convexity effect has been shown in the following diagram:
8.13 Convertible Debentures

Convertible Debentures are those debentures which are converted in equity shares after certain
period of time. The number of equity shares for each convertible debenture are called Conversion
Ratio and price paid for the equity share is called ‘Conversion Price’.
Further, conversion value of debenture is equal to Price per Equity Share x Converted No. of
Shares per Debenture.
8.14 Valuation of Warrants
A warrant is a right that entitles a holder to subscribe equity shares during a specific period at a
stated price. These are generally issued to sweeten the debenture issue.
Although both convertible Debentures and Warrants appeared to one and same thing but following
are major differences.
(i) In warrant, option of conversion is detachable while in convertible it is not so. Due to this
reason, warrants can be separately traded.
(ii) Warrants are exercisable for cash payment while convertible debenture does not involve
any such cash payment.
Theoretical value of warrant can be found as follows:
(MP – E) x n
MP = Current Market Price of Share
E = Exercise Price of Warrant
n = No. of equity shares convertible with one warrant
8.15 Zero Coupon Bond
As name indicates these bonds do not pay any coupon during the life of the bonds. Instead, Zero
Coupon Bonds (ZCBs) are issued at discounted price to their face value, which is the amount a
bond will be worth when it matures or comes due. When a ZCB matures, the investor will receive
one lump sum (face value) equal to the initial investment plus interest that has been accrued on
the investment made. The maturity dates on ZCBs are usually long term. These maturity dates
allow an investor for a long-range planning. ZCBs issued by banks, government and private sector
companies. However, bonds issued by corporate sector carry a potentially higher degree of risk,
depending on the financial strength of the issuer and longer maturity period, but they also pro vide
an opportunity to achieve a higher return.
8.16 Money Market Instruments
Similar to Bonds, the money market instruments are important source of finance to industry, trade,
commerce and the government sector for meeting their short-term requirement for both national
and international trade. These financial instruments provide also an investment opportunity to the
banks and others to deploy their surplus funds so as to reduce their cost of liquidity and earn some
income.
The instruments of money market are characterised by
(a) Short duration,
(b) Large volume
(c) De–regulated interest rates.
(d) The instruments are highly liquid.
(e) They are safe investments owing to issuers inherent financial strength.
The traditional short-term money market instruments consist of mainly call money and notice
money with limited players, treasury bills and commercial bills. The new money market instruments
were introduced giving a wider choice to short term holders of money to reap yield on funds even
for a day to earn a little more by parking funds through instruments for a few days more or until
such time till they need it for lending at a higher rate. The various types of instruments of money
market are discussed in the following paragraphs:
8.16.1 Call/Notice money: Call money market, or inter-bank call money market, is a segment of
the money market where scheduled commercial banks lend or borrow on call (i.e., overnight) or at
short notice (i.e., for periods upto 14 days) to manage the day-to-day surpluses and deficits in their
cash-flows.
However, under notice money market, funds are transacted for a period between two days and
fourteen days. These day to day surpluses and deficits arises due to the v ary nature of their
operations and the peculiar nature of the portfolios of their assets and liabilities.
8.16.2 Treasury Bills (TBs): Among money market instruments TBs provide a temporary outlet for
short-term surplus as also provide financial instruments of varying short-term maturities to facilitate
a dynamic asset-liabilities management. The interest received on them is the discount which is the
difference between the price at which they are issued and their redemption value. They have
assured yield and negligible risk of default. The TBs are short-term promissory notes issued by
Government of India at a discount.
More relevant to the money market is the introduction of 14 days, 28 days, 91 days and 364 days
TBs on auction basis.
However, at present, the RBI issues Treasury Bills of three maturities i.e. 91 days, 182 days and
364 days.
TBs are issued at discount and their yields can be calculated with the help of the following formula:
 F − P  365
Y=   100
 P  M
where Y = Yield,
F = Face Value,
P = Issue Price/Purchase Price,
M = Actual days to Maturity.
8.16.3 Commercial Bills: A commercial bill is one which arises out of a genuine trade transaction,
i.e. credit transaction. As soon as goods are sold on credit, the seller draws a bill on the buyer for
the amount due. The buyer accepts it immediately agreeing to pay amount mentioned therein after
a certain specified date. Thus, a bill of exchange contains a written order from the creditor to the
debtor, to pay a certain sum, to a certain person, after a creation period. A bill of exchange is a
‘self-liquidating’ paper and negotiable; it is drawn always for a short period ranging between 3
months and 6 months.
Bill financing is the core component of meeting working capital needs of corporates in developed
countries. Such a mode of financing facilitates an efficient payment system. The commercial bill is
instrument drawn by a seller of goods on a buyer of goods. RBI has pioneered its efforts in
developing bill culture in India, keeping in mind the distinct advantages of commercial bills, like,
self-liquidating in nature, recourse to two parties, knowing exact date transactions, transparency of
transactions etc.
Example
If a bank re-discounted a commercial bill with a face value of ` 100/- @ 15% for 2 months will
fetch ` 97.50, on the basis of the following calculation.
15 2
Discount = 100   = ` 2.50
100 12
However, as the discount amount is paid at front-end.
Example
The yield to the investor or cost to the borrower will be higher than the discount rate in view of the
fact that the discounter can deploy the amount of discount received for earning further income.
This can be calculated with the following formula:
FV - SV Days or months in a year
D= × × 100
SV M
where
D = Effective Discounting Rate
FV = Face Value
SV = Sale Value
M = Period of Discount
Accordingly, the Yield as per the data given in the example will be:
100 - 97.50 12
× × 100 = 15.385%
97.50 2
8.16.4 Call/Notice money: The CDs are negotiable term-deposits accepted by commercial bank
from bulk depositors at market related rates. CDs are usually issued in demat fo rm or as a Usance
Promissory Note.
Just like Commercial Bills, Certificate of Deposit (CD) is a front–ended negotiable instrument,
issued at a discount and the face value is payable at maturity by the issuing bank.
Example
Amount of Issue – ` 100
Period - 6 months
Rate of discount – 20%
20 6
Discount = 100   = ` 10.00
100 12
Hence CD will be issued for ` 100 – 10 = ` 90.00. The effective rate to the bank will, however, be
calculated on the basis of the following formula:
E= × × 100
SV M
where
E = Effective Yield
FV = Face Value
SV = Sale Value
Accordingly, the Yield as per the data given in the example will be:
100 - 90 12
× × 100 = 22.22%
90 6
8.16.5 Commercial Paper: Commercial Paper (CP) has its origin in the financial markets of
America and Europe. The concept of CPs was originated in USA in early 19th century when
commercial banks monopolised and charged high rate of interest on loans and advances. In India,
the CP was introduced in January 1990 on the recommendation of Vaghul Committee subject to
various conditions. When the process of financial dis-intermediation started in India in 1990, RBI
allowed issue of two instruments, viz., the Commercial Paper (CP) and the Certificate of Deposit
(CD) as a part of reform in the financial sector. A notable feature of RBI Credit Policy announced
on 16.10.1993 was the liberalisation of terms of issue of CP. At present it provides cheap source
of funds for corporate sector and has caught the fancy of corporate sector and banks. Its market
has picked up considerably in India due to interest rate differentials in the inter -bank and
commercial lending rates.
CPs are unsecured and negotiable promissory notes issued by high rated corp orate entities to
raise short-term funds for meeting working capital requirements directly from the market instead of
borrowing from banks. Its period ranges from 7 days to 1 year. CP is issued at discount to face
value The issue of CP seeks to by-pass the intermediary role of the banking system through the
process of securitisation.
It partly replaces the working capital limits enjoyed by companies with the commercial banks and
there will be no net increase in their borrowing by issue of CP. Generally, CP has to be issued at a
discount to face value. Yield on CP is freely determined by the market.
The yield on CP can be calculated as follows:
Y= × × 100
SV M
where
Y = Yield
FV = Face Value
SV = Sale Value
8.16.6 Repurchase Options (Repo.) and Reverse Repurchase Agreement (Reverse Repo):
The term Repurchase Agreement (Repo) and Reverse Repurchase Agreement (Reverse Repo)
refer to a type of transaction in which money market participant raises funds by selling securi ties
and simultaneously agreeing to repurchase the same after a specified time generally at a specified
price, which typically includes interest at an agreed upon rate. Sometimes it is also called Ready
Forward Contract as it involves funding by selling securities (held on Spot i.e. Ready Basis) and
repurchasing them on a forward basis.
Following are major differences between Repo and Reverse Repo:
(a) Repo rate is the rate at which Reserve Bank of India (RBI) lends to Commercial Banks for a
short period of time against Government Securities. On the other hand, Reverse Repo is the
rate at which Commercial Banks lend to RBI.
(b) A transaction is called a Repo when viewed from the perspective of the seller of securities
(the party acquiring funds) and Reverse Repo when described from the point of view of the
supplier of funds. Thus, whether a given agreement is termed a Repo or a Reverse Repo
depends largely on which party initiated the transaction.
(c) The purpose of Repo is to fulfill the deficiency of funds. While the purpose of Reverse repo is
to reduce excess liquidity in the economy.
(d) The Repo rate is comparatively high in comparison to Reverse Repo rate.
(e) The Repo rate strives to contain inflation in the economy. The Reverse repo aims to control
money supply in the economy.
TEST YOUR KNOWLEDGE

1. Why should the duration of a coupon carrying bond always be less than the time to its
maturity?
2. Write short notes on Zero Coupon Bonds.
Practical Questions
1. A company has a book value per share of ` 137.80. Its return on equity is 15% and it
follows a policy of retaining 60% of its earnings. If the Opportunity Cost of Capital is 18%,
compute is the price of the share today using both Dividend Growth Model and Walter’s
Model.
2. ABC Limited’s shares are currently selling at ` 13 per share. There are 10,00,000 shares
outstanding. The firm is planning to raise ` 20 lakhs to Finance a new project.
Required:
What are the ex-right price of shares and the value of a right, if
(i) The firm offers one right share for every two shares held.
(ii) The firm offers one right share for every four shares held.
(iii) How does the shareholders’ wealth (holding 100 shares) change from (i) to (ii)? How
does right issue increases shareholders’ wealth?
3. MNP Ltd. has declared and paid annual dividend of ` 4 per share. It is expected to grow @
20% for the next two years and 10% thereafter. The required rate of return of equit y
investors is 15%. Compute the current price at which equity shares should sell.
Note: Present Value Interest Factor (PVIF) @ 15%:
For year 1 = 0.8696;
For year 2 = 0.7561
4. On the basis of the following information:
Current dividend (Do) = ` 2.50
Discount rate (k) = 10.5%
Growth rate (g) = 2%
(i) Calculate the present value of stock of ABC Ltd.
(ii) Is its stock overvalued if stock price is ` 35, ROE = 9% and EPS = ` 2.25? Show
detailed calculation. Using PE Multiple Approach and Earning Growth Model.
5. X Limited, just declared a dividend of ` 14.00 per share. Mr. B is planning to purchase the
share of X Limited, anticipating increase in growth rate from 8% to 9%, which will continue
for three years. He also expects the market price of this share to be ` 360.00 after three
years.
You are required to determine:
(i) the maximum amount Mr. B should pay for shares, if he requires a rate of return of
13% per annum.
(ii) the maximum price Mr. B will be willing to pay for share, if he is of the opinion that
the 9% growth can be maintained indefinitely and require 13% rate of return per
annum.
(iii) the price of share at the end of three years, if 9% growth rate is achieved and
assuming other conditions remaining same as in (ii) above.
Calculate rupee amount up to two decimal points.
Year-1 Year-2 Year-3
FVIF @ 9% 1.090 1.188 1.295
FVIF @ 13% 1.130 1.277 1.443
PVIF @ 13% 0.885 0.783 0.693
6. Piyush Loonker and Associates presently pay a dividend of Re. 1.00 per share and has a
share price of ` 20.00.
(i) If this dividend were expected to grow at a rate of 12% per annum forever, what is
the firm’s expected or required return on equity using a dividend-discount model
approach?
(ii) Instead of this situation in part (i), suppose that the dividends were expected to grow
at a rate of 20% per annum for 5 years and 10% per year thereafter. Now what is the
firm’s expected, or required, return on equity?
7. Capital structure of Sun Ltd., as at 31.3.2003 was as under:
(` in lakhs)
Equity share capital 80
8% Preference share capital 40
12% Debentures 64
Reserves 32
Sun Ltd., earns a profit of ` 32 lakhs annually on an average before deduction of income-
tax, which works out to 35%, and interest on debentures.
Normal return on equity shares of companies similarly placed is 9.6% provided:

(a) Profit after tax covers fixed interest and fixed dividends at least 3 times.
(b) Capital gearing ratio is 0.75.
(c) Yield on share is calculated at 50% of profits distributed and at 5% on undistributed
profits.
Sun Ltd., has been regularly paying equity dividend of 8%.
Compute the value per equity share of the company assuming:
(i) 1% for every one time of difference for Interest and Fixed Dividend Coverage.
(ii) 2% for every one time of difference for Capital Gearing Ratio.
8. ABC Ltd. has been maintaining a growth rate of 10 percent in dividends. The comp any has
paid dividend @ ` 3 per share. The rate of return on market portfolio is 12 percent and the
risk free rate of return in the market has been observed as 8 percent. The Beta co -efficient
of company’s share is 1.5.
You are required to calculate the expected rate of return on company’s shares as per
CAPM model and equilibrium price per share by dividend growth model.
9. A Company pays a dividend of ` 2.00 per share with a growth rate of 7%. The risk free rate
is 9% and the market rate of return is 13%. The Company has a beta factor of 1.50.
However, due to a decision of the Finance Manager, beta is likely to increase to 1.75. Find
out the present as well as the likely value of the share after the decision.
10. Calculate the value of share from the following information:
Profit after tax of the company ` 290 crores
Equity capital of company ` 1,300 crores
Par value of share ` 40 each
Debt ratio of company (Debt/ Debt + Equity) 27%
Long run growth rate of the company 8%
Beta 0.1; risk free interest rate 8.7%
Market returns 10.3%
Capital expenditure per share ` 47
Depreciation per share ` 39
Change in Working capital ` 3.45 per share
11. Shares of Voyage Ltd. are being quoted at a price-earning ratio of 8 times. The company
retains ` 5 per share which is 45% of its Earning Per Share.
You are required to compute
(i) The cost of equity to the company if the market expects a growth rate of 15% p.a.
(ii) If the anticipated growth rate is 16% per annum, calculate the indicative market price
with the same cost of capital.
(iii) If the company's cost of capital is 20% p.a. & the anticipated growth rate is 19% p.a. ,
calculate the market price per share.
12. Following Financial data are available for PQR Ltd. for the year 2008:
(` in lakh)
8% debentures 125
10% bonds (2007) 50
Equity shares (` 10 each) 100
Reserves and Surplus 300
Total Assets 600
Assets Turnovers ratio 1.1
Effective interest rate 8%
Effective tax rate 40%
Operating margin 10%
Dividend payout ratio 16.67%
Current market Price of Share ` 14
Required rate of return of investors 15%
You are required to:
(i) Draw income statement for the year
(ii) Calculate its sustainable growth rate of earnings
(iii) Calculate the fair price of the Company's share using dividend discount model, and
(iv) What is your opinion on investment in the company's share at current price?
13. M/s X Ltd. has paid a dividend of ` 2.50 per share on a face value of ` 10 in the financial
year ending on 31st March, 2009. The details are as follows:
Current market price of share ` 60
Growth rate of earnings and dividends 10%
Beta of share 0.75

Average market return 15%
Risk free rate of return 9%
Calculate the intrinsic value of the share.
14. Mr. A is thinking of buying shares at ` 500 each having face value of ` 100. He is expecting
a bonus at the ratio of 1: 5 during the fourth year. Annual expected dividend is 20% and the
same rate is expected to be maintained on the expanded capital base. He intends to sell the
shares at the end of seventh year at an expected price of ` 900 each. Incidental expenses
for purchase and sale of shares are estimated to be 5% of the market price. He expects a
minimum return of 12% per annum.
Should Mr. A buy the share? If so, what maximum price should he pay for each share?
Assume no tax on dividend income and capital gain.
15. The risk free rate of return Rf is 9 percent. The expected rate of return on the market
portfolio Rm is 13 percent. The expected rate of growth for the dividend of Platinum Ltd. is 7
percent. The last dividend paid on the equity stock of firm A was ` 2.00. The beta of
Platinum Ltd. equity stock is 1.2.
(i) What is the equilibrium price of the equity stock of Platinum Ltd.?
(ii) How would the equilibrium price change when
• The inflation premium increases by 2 percent?
• The expected growth rate increases by 3 percent?
• The beta of Platinum Ltd. equity rises to 1.3?
16. SAM Ltd. has just paid a dividend of ` 2 per share and it is expected to grow @ 6% p.a.
After paying dividend, the Board declared to take up a project by retaining the next three
annual dividends. It is expected that this project is of same risk as the existing projects. The
results of this project will start coming from the 4 th year onward from now. The dividends will
then be ` 2.50 per share and will grow @ 7% p.a.
An investor has 1,000 shares in SAM Ltd. and wants a receipt of at least ` 2,000 p.a. from
this investment.
Show that the market value of the share is affected by the decision of the Board. Also show
as to how the investor can maintain his target receipt from the investment for first 3 years
and improved income thereafter, given that the cost of capital of the firm is 8%.
17. XYZ Ltd. paid a dividend of ` 2 for the current year. The dividend is expected to grow at
40% for the next 5 years and at 15% per annum thereafter. The return on 182 days T -bills is
11% per annum and the market return is expected to be around 18% with a variance of
24%.
The co-variance of XYZ's return with that of the market is 30%. You are required to
calculate the required rate of return and intrinsic value of the stock.
18. Rahul Ltd. has surplus cash of ` 100 lakhs and wants to distribute 27% of it to the
shareholders. The company decides to buy back shares. The Finance Manager of the
company estimates that its share price after re-purchase is likely to be 10% above the
buyback price-if the buyback route is taken. The number of shares outstanding at present is
10 lakhs and the current EPS is ` 3.
(i) The price at which the shares can be re-purchased, if the market capitalization of the
company should be ` 210 lakhs after buyback,
(ii) The number of shares that can be re-purchased, and
(iii) The impact of share re-purchase on the EPS, assuming that net income is the same.
19. Nominal value of 10% bonds issued by a company is `100. The bonds are redeemable at
` 110 at the end of year 5. Determine the value of the bond if required yield is (i) 5%, (ii)
5.1%, (iii) 10% and (iv) 10.1%.
20. An investor is considering the purchase of the following Bond:
Face value ` 100
Coupon rate 11%
Maturity 3 years
(i) If he wants a yield of 13% what is the maximum price, he should be ready to pay for?
(ii) If the Bond is selling for ` 97.60, what would be his yield?
21. Calculate Market Price of:
(i) 10% Government of India security currently quoted at ` 110, but yield is expected to
go up by 1%.
(ii) A bond with 7.5% coupon interest, Face Value ` 10,000 & term to maturity of 2
years, presently yielding 6% . Interest payable half yearly.
22. A convertible bond with a face value of ` 1,000 is issued at ` 1,350 with a coupon rate of
10.5%. The conversion rate is 14 shares per bond. The current market price of bond and
share is ` 1,475 and ` 80 respectively. What is the premium over conversion value?
23. Saranam Ltd. has issued convertible debentures with coupon rate 12%. Each debenture
has an option to convert to 20 equity shares at any time until the date of maturity.
Debentures will be redeemed at ` 100 on maturity of 5 years. An investor generally requires

a rate of return of 8% p.a. on a 5-year security. As an investor when will you exercise
conversion for given market prices of the equity share of (i) ` 4, (ii) ` 5 and (iii) ` 6.
Cumulative PV factor for 8% for 5 years : 3.993
PV factor for 8% for year 5 : 0.681
24. The data given below relates to a convertible bond :
Face value ` 250

Coupon rate 12%
No. of shares per bond 20
Market price of share ` 12
Straight value of bond ` 235
Market price of convertible bond ` 265
Calculate:
(i) Stock value of bond.
(ii) The percentage of downside risk.
(iii) The conversion premium
(iv) The conversion parity price of the stock.
25. ABC Ltd. has ` 300 million, 12 per cent bonds outstanding with six years remaining to
maturity. Since interest rates are falling, ABC Ltd. is contemplating of refunding these
bonds with a ` 300 million issue of 6 year bonds carrying a coupon rate of 10 per cent.
Issue cost of the new bond will be ` 6 million and the call premium is 4 per cent. ` 9 million
being the unamortized portion of issue cost of old bonds can be written off no sooner the
old bonds are called off. Marginal tax rate of ABC Ltd. is 30 per cent. You are required to
analyse the bond refunding decision.
26. The following data are available for a bond
Face value ` 1,000
Coupon Rate 16%
Years to Maturity 6
Redemption value ` 1,000
Yield to maturity 17%
What is the current market price, duration and volatility of this bond? Calculate the expected
market price, if increase in required yield is by 75 basis points.
27. Mr. A will need ` 1,00,000 after two years for which he wants to make one time necessary
investment now. He has a choice of two types of bonds. Their details are as below:
Bond X Bond Y
Face value ` 1,000 ` 1,000
Coupon 7% payable annually 8% payable annually
Years to maturity 1 4
Current price ` 972.73 ` 936.52
Current yield 10% 10%
Advice Mr. A whether he should invest all his money in one type of bond or he should buy
both the bonds and, if so, in which quantity? Assume that there will not be any call risk or
default risk.
28. RBI sold a 91-day T-bill of face value of ` 100 at an yield of 6%. What was the issue price?
29. Wonderland Limited has excess cash of ` 20 lakhs, which it wants to invest in short term
marketable securities. Expenses relating to investment will be ` 50,000.
The securities invested will have an annual yield of 9%.
The company seeks your advice
(i) as to the period of investment so as to earn a pre-tax income of 5%. (discuss)
(ii) the minimum period for the company to breakeven its investment expenditure
overtime value of money.
30. Z Co. Ltd. issued commercial paper worth `10 crores as per following details:
Date of issue : 16th January, 2019
Date of maturity: 17th April, 2019
No. of days : 91
Interest rate 12.04% p.a
What was the net amount received by the company on issue of CP? (Charges of
intermediary may be ignored)
31. Bank A enter into a Repo for 14 days with Bank B in 10% Government of India Bonds 2028
@ 5.65% for ` 8 crore. Assuming that clean price (the price that does not have accrued
interest) be ` 99.42 and initial Margin be 2% and days of accrued interest be 262 days. You
are required to determine
(i) Dirty Price
(ii) Repayment at maturity. (consider 360 days in a year)
ANSWERS/SOLUTIONS
1. The company earnings and dividend per share after a year are expected to be:
EPS = ` 137.8  0.15 = ` 20.67
Dividend = 0.40  20.67 = ` 8.27
The growth in dividend would be:
g = 0.6  0.15 = 0.09
(a) As per Dividend Growth Model
Dividend
Perpetual growth model Formula : P0 =
Ke - g
8.27
P =
0 0.18 - 0.09
P0 = ` 91.89
(b) Walter’s approach showing relationship between dividend and share price can be
expressed by the following formula
Ra
D+ (E - D)
Rc
Vc =
Rc
Where,
Vc = Market Price of the ordinary share of the company.
Ra = Return on internal retention i.e. the rate company earns on retained profits.
Rc = Capitalisation rate i.e. the rate expected by investors by way of return from
particular category of shares.
E = Earnings per share.
D = Dividend per share.
Hence,
.15
8.27 + (20.67 - 8.27) 18.60
Vc = .18 =
.18 .18
= ` 103.35
2. (i) Number of shares to be issued : 5,00,000
Subscription price ` 20,00,000 / 5,00,000 = ` 4
` 1,30,00,000 + ` 20,00,000
Ex-right Pr ice = = ` 10
15,00,000
Value of a Right = ` 10 – ` 4 = ` 6
` 10 − ` 4
Value of a Right Per Share Basis = = `3
2
(ii) Subscription price ` 20,00,000 / 2,50,000 = ` 8
` 1,30,00,000 + ` 20,00,000
Ex-right Pr ice = = ` 12
12,50,000
Value of a Right = ` 12 – ` 8 = ` 4
` 12 − ` 8
Value of a Right Per Share = = `1
4
(iii) Calculation of effect of right issue on wealth of Shareholder’s wealth who is holding
100 shares.
(a) When firm offers one share for two shares held.
Value of Shares after right issue (150 X ` 10) ` 1,500
Less: Amount paid to acquire right shares (50X`4) ` 200
` 1,300
(b) When firm offers one share for every four shares held.
Value of Shares after right issue (125 X ` 12) ` 1,500
Less: Amount paid to acquire right shares (25X`8) ` 200
` 1,300
(c) Wealth of Shareholders before Right Issue ` 1,300
Thus, there will be no change in the wealth of shareholders from (i) and (ii).
3. D0 = ` 4
D1 = ` 4 (1.20) = ` 4.80
D2 = ` 4 (1.20)2 = ` 5.76
D3 = ` 4 (1.20)2 (1.10) = ` 6.336
D1 D2 TV
P= +
2
+
2
(1+ k e ) (1+ k e ) (1+ k e )
D3 6.336
TV = = = 126.72
ke - g 0.15 - 0.10
4.80 5.76 126.72

P= + +
(1+ 0.15) (1+ 0.15)2 (1+ 0.15)2
= 4.80 x 0.8696 + 5.76 x 0.7561 + 126.72 x 0.7561 = 104.34

4. (i) Present Value of the stock of ABC Ltd. Is:-
2.50(1.02)
Vo = = `30/-.
0.105 − 0.02
(ii) (A) Value of stock under the PE Multiple Approach
Particulars
Actual Stock Price ` 35.00
Return on equity 9%
EPS ` 2.25
PE Multiple (1/Return on Equity) = 1/9% 11.11
Market Price per Share ` 25.00
Since, Actual Stock Price is higher, hence it is overvalued.
(B) Value of the Stock under the Earnings Growth Model
Particulars
Actual Stock Price ` 35.00
Return on equity 9%
EPS ` 2.25
Growth Rate 2%
Market Price per Share [EPS ×(1+g)]/(K e – g) ` 32.79
= ` 2.25 × 1.02/0.07
Since, Actual Stock Price is higher, hence it is overvalued.
5. (i) Expected dividend for next 3 years.

Year 1 (D1) ` 14.00 (1.09) = ` 15.26
Year 2 (D2) ` 14.00 (1.09)2 = ` 16.63
Year 3 (D3) ` 14.00 (1.09) 3 = ` 18.13
Required rate of return = 13% (Ke)
Market price of share after 3 years = (P 3) = ` 360
The present value of share
D1 D2 D3 P3
P0 = + + +
(1 + ke ) (1 + ke ) (1 + ke ) (1 + ke )3
2 3
P0 = 15.26 16.63 18.13 360

+ + +
(1 + 0.13 ) (1 + 0.13 ) (1 + 0.13 ) (1 + 0.13 )3
2 3
P0 = 15.26(0.885) + 16.63(0.783) +18.13(0.693)+360(0.693)

P0 = 13.50 + 13.02 + 12.56 + 249.48
P0 = ` 288.56
(ii) If growth rate 9% is achieved for indefinite period, then maximum price of share
should Mr. A willing be to pay is
D1 ` 15.26 ` 15.26
P0 = = = = ` 381.50
(ke − g) 0.13-0.09 0.04
(iii) Assuming that conditions mentioned above remain same, the price expected after 3
years will be:
D4 D 3 (1.09) 18.13  1.09 19.76
P3 = = = = = ` 494
k e − g 0.13 − 0.09 0.04 0.04
6. (i) Firm’s Expected or Required Return on Equity

(Using a dividend discount model approach)
According to Dividend discount model approach the firm’s expected or required
return on equity is computed as follows:
D1
Ke = +g
P0
Where,
Ke = Cost of equity share capital or (Firm’s expected or required return
on equity share capital)
D1 = Expected dividend at the end of year 1

P0 = Current market price of the share.
g = Expected growth rate of dividend.
Now, D1 = D0 (1 + g) or ` 1 (1 + 0.12) or ` 1.12, P0 = ` 20 and g = 12% per annum
` 1.12
Therefore, K e = + 12%
` 20
Or, Ke = ` 17.6%
(ii) Firm’s Expected or Required Return on Equity
(If dividends were expected to grow at a rate of 20% per annum for 5 years and 10%
per year thereafter)
Since in this situation if dividends are expected to grow at a super normal growth
rate gs, for n years and thereafter, at a normal, perpetual growth rate of gn beginning
in the year n + 1, then the cost of equity can be determined by using the following
formula:
n
Div 0 (1 + gs ) t Div n + 1
P0 =  +
t =1 (1 + K e ) t K e - gn
Where,
gs = Rate of growth in earlier years.
gn = Rate of constant growth in later years.
P0 = Discounted value of dividend stream.
Ke = Firm’s expected, required return on equity (cost of equity capital).
Now,
gs = 20% for 5 years, g n = 10%
Therefore,
n
D 0 (1 + 0.20)t Div 5 + 1 1
P0 = ∑ (1 + K e ) t
+ ×
K e - 0.10 (1 + K e ) t
t =1
1.20 1.44 1.73 2.07 2.49 2.49 (1 + 0.10) 1

0P = 1 + 2 + 3 + 4 + 5 +  5
(1 + K
e) (1 + K
e) (1 + K
e) (1 + K
e) (1 + K
e)
K
e - 0.10 (1 + K
e)
or P0 = ` 1.20 (PVF1, Ke) + ` 1.44 (PVF2, Ke) + ` 1.73 (PVF 3, Ke) + ` 2.07
Rs. 2.74 (PVF5 , K e )

(PVF4, Ke) + ` 2.49 (PVF5, Ke) +
K e - 0.10
By trial and error we are required to find out K e

Now, assume Ke = 18% then we will have
P0 = ` 1.20 (0.8475) + ` 1.44 (0.7182) + ` 1.73 (0.6086) + ` 2.07 (0.5158) + ` 2.49
1
(0.4371) + ` 2.74 (0.4371) 
0.18 - 0.10
= ` 1.017 + ` 1.034 + ` 1.053 + ` 1.068 + ` 1.09 + ` 14.97= ` 20.23
Since the present value of dividend stream is more than required it indicates that Ke
is greater than 18%.
Now, assume Ke = 19% we will have
P0 = ` 1.20 (0.8403) + ` 1.44 (0.7061) + ` 1.73 (0.5934) + ` 2.07 (0.4986) + ` 2.49
1
(0.4190) + ` 2.74 (0.4190) 
0.19 - 0.10
= ` 1.008 + ` 1.017 + ` 1.026+ ` 1.032 + ` 1.043 + ` 12.76
= ` 17.89
Since the market price of share (expected value of dividend stream) is ` 20.
Therefore, the discount rate is closer to 18% than it is to 19%, we can get the exact
rate by interpolation by using the following formula:
NPV at LR
K e = LR + × Δr
NPV at LR - NPV at HR
Where,
LR = Lower Rate
NPV at LR = Present value of share at LR
NPV at HR = Present value of share at Higher Rate
r = Difference in rates
(` 20.23 −` 20)
K e = 18% +  1%
R` 20.23 − ` 17.89
` 0.23
=18% +  1%
`2.34
= 18% + 0.10% = 18.10%
Therefore, the firm’s expected, or required, return on equity is 18.10%. At this rate the
present discounted value of dividend stream is equal to the market price of the share.
7. (a) Calculation of Profit after tax (PAT)
`
Profit before interest and tax (PBIT) 32,00,000
Less: Debenture interest (` 64,00,000 × 12/100) 7,68,000
Profit before tax (PBT) 24,32,000
Less: Tax @ 35% 8,51,200
Profit after tax (PAT) 15,80,800
Less: Preference Dividend
(` 40,00,000 × 8/100) 3,20,000
Equity Dividend (` 80,00,000 × 8/100) 6,40,000 9,60,000
Retained earnings (Undistributed profit) 6,20,800
Calculation of Interest and Fixed Dividend Coverage

PAT + Debenture interest PAT + Debenture Interest Net of Tax
= or
Debenture interest + Preference dividend Debenture interest + Preference dividend
15,80,800 + 7,68,000 15,80,800 + 4,99,200
= or
7,68,000 + 3,20,000 7,68,000 + 3,20,000
23,48,800 20,80,000
= or = 2.16 times or 1.91 times
10,88,000 10,88,000
(b) Calculation of Capital Gearing Ratio

Fixed interest bearing funds
Capital Gearing Ratio =
Equity shareholders' funds
Preference Share Capital + Debentures 40,00,000 + 64,00,000 1,04,00,000

= = = = 0.93
Equity Share Capital + Reserves 80,00,000 + 32,00,000 1,12,00,000
(c) Calculation of Yield on Equity Shares:

Yield on equity shares is calculated at 50% of profits distributed and 5% on
undistributed profits:
(`)
50% on distributed profits (` 6,40,000 × 50/100) 3,20,000
5% on undistributed profits (` 6,20,800 × 5/100) 31,040
Yield on equity shares 3,51,040
Yield on shares
Yield on equity shares % =  100
Equity share capital
3,51,040
=  100 = 4.39% or, 4.388%.
80,00,000
Calculation of Expected Yield on Equity shares

(a) Interest and fixed dividend coverage of Sun Ltd. is 2.16 times but the industry
average is 3 times. Therefore, risk premium is added to Sun Ltd. Shares @ 1% for
every 1 time of difference.
Risk Premium = 3.00 – 2.16 (1%) = 0.84 (1%) = 0.84%
(b) Capital Gearing ratio of Sun Ltd. is 0.93 but the industry average is 0.75 times.
Therefore, risk premium is added to Sun Ltd. shares @ 2% for every 1 time of
difference.
Risk Premium = (0.75 – 0.93) (2%)
= 0.18 (2%) = 0.36%
(%)
Normal return expected 9.60
Add: Risk premium for low interest and fixed dividend coverage 0.84
Add: Risk premium for high interest gearing ratio 0.36
10.80
Value of Equity Share
Actual yield 4.39
=  Paid-up value of share =  100 = ` 40.65
Expected yield 10.80
8. CAPM formula for calculation of Expected Rate of Return is :

ER = Rf + β (Rm – Rf)
= 8 + 1.5 (12 – 8)
= 8 + 1.5 (4)
=8+6
=14% or 0.14
Applying Dividend Growth Model for the calculation of per share equilibrium price:
D1
ER = +g
P0
3 (1.10)
0.14 = + 0.10
P0
3.30
0.14 – 0.10 =
P0
0.04 P0 = 3.30
3.30
P0 = = ` 82.50
0.04
Per share equilibrium price will be ` 82.50.
9. In order to find out the value of a share with constant growth model, the value of K e should
be ascertained with the help of ‘CAPM’ model as follows:
Ke = Rf +  (Km – Rf)
Where,
Ke = Cost of equity
Rf = Risk free rate of return
 = Portfolio Beta i.e. market sensitivity index
Km = Expected return on market portfolio
By substituting the figures, we get
Ke = 0.09 + 1.5 (0.13 – 0.09) = 0.15 or 15%
and the value of the share as per constant growth model is
D1
P0 =
(k e - g)
Where,
P0 = Price of a share
D1 = Dividend at the end of the year 1
Ke = Cost of equity
g = growth
2.00
P0 =
(k e - g)
2.00
P0 =
0.15 - 0.07 = ` 25.00
Alternatively, it can also be found as follows:

2.00 (1.07)
= ` 26.75
0.15 - 0.07
However, if the decision of finance manager is implemented, the beta () factor is likely to
increase to 1.75 therefore, K e would be
Ke = Rf +  (Km – Rf)
= 0.09 + 1.75 (0.13 – 0.09) = 0.16 or 16%
The value of share is
D1
P0 =
(k e - g)
2.00
P0 =
0.16 - 0.07 = ` 22.22
Alternatively, it can also be found as follows:

2.00 (1.07)
= ` 23.78
0.16 - 0.07
` 1,300 crores
10. No. of Shares = = 32.5 Crores
` 40
PAT
EPS =
No.of shares
` 290 crores
EPS = = ` 8.923
32.5 crores
FCFE = Net income – [(1-b) (capex – dep) + (1-b) ( ΔWC )]

FCFE = 8.923 – [(1-0.27) (47-39) + (1-0.27) (3.45)]
= 8.923 – [5.84 + 2.5185] = 0.5645
Cost of Equity = R f + ß (Rm – Rf)
= 8.7 + 0.1 (10.3 – 8.7) = 8.86%
FCFE(1+ g) 0.5645(1.08) 0.60966
Po = = = = ` 70.89
Ke − g 0.0886 − .08 0.0086
11. (i) Cost of Capital

Retained earnings (45%) ` 5 per share
Dividend (55%) ` 6.11 per share
EPS (100%) ` 11.11 per share
P/E Ratio 8 times
Market price ` 11.11  8 = ` 88.88
Cost of equity capital

 Div  ` 6.11
= 100  + Growth % =  100 +15% = 21.87%
 Pr ice  ` 88.88
 Dividend 
(ii) Market Price =  
 Cost of Capital(% ) - Growth Rate(% ) 
` 6.11
= = ` 104.08 per share
(21.87-16)%
` 6.11
(iii) Market Price = = ` 611.00 per share
(20-19)%
12. Workings:
Asset turnover ratio = 1.1
Total Assets = ` 600
Turnover ` 600 lakhs × 1.1 = ` 660 lakhs
Interest
Effective interest rate = = 8%
Libilities
Liabilities = ` 125 lakhs + 50 lakhs = 175 lakh
Interest = ` 175 lakhs × 0.08 = ` 14 lakh
Operating Margin = 10%
Hence operating cost = (1 - 0.10) ` 660 lakhs = ` 594 lakh
Dividend Payout = 16.67%
Tax rate = 40%
(i) Income statement
(` Lakhs)
Sale 660
Operating Exp 594
EBIT 66
Interest 14
EBT 52
Tax @ 40% 20.80
EAT 31.20
Dividend @ 16.67% 5.20
Retained Earnings 26.00
(ii) SGR = ROE (1-b)

PAT
ROE = and NW =` 100 lakh + ` 300 lakh = 400 lakh
NW
` 31.2 lakhs
ROE = х 100 = 7.8%
` 400 lakhs
0.078×0.8333
SGR = 0.078(1 - 0.1667) = 6.5% or = 6.95%
1-0.078×0.8333
(iii) Calculation of fair price of share using dividend discount model
Do (1 + g)
Po =
ke − g
` 5.2 lakhs
Dividends = = ` 0.52
` 10 lakhs
Growth Rate = 6.5% or 6.95%
` 0.52(1 + 0.065) ` 0.5538 0.52(1+ 0.0695)
Hence Po = = = ` 6.51 or
0.15-0.065 0.085 0.15- 0.0695
0.5561
= = ` 6.91
0.0805
(iv) Since the current market price of share is ` 14, the share is overvalued. Hence the
investor should not invest in the company.
D1
13. Intrinsic Value P 0=
k−g
Using CAPM
k = Rf + (Rm-Rf)
Rf = Risk Free Rate
 = Beta of Security
Rm = Market Return
= 9% + 0.75 (15% - 9%) = 13.5%
2.5 1.1 2.75
P= = = ` 78.57
0.135- 0.10 0.035
14. P.V. of dividend stream and sales proceeds
Year Divd. /Sale PVF (12%) PV (`)

1 ` 20/- 0.893 17.86
2 ` 20/- 0.797 15.94
3 ` 20/- 0.712 14.24
4 ` 24/- 0.636 15.26
5 ` 24/ 0.567 13.61
6 ` 24/ 0.507 12.17
7 ` 24/ 0.452 10.85
7 ` 1026/- (` 900 x 1.2 x 0.95) 0.452 463.75
` 563.68
Less : - Cost of Share (` 500 x 1.05) ` 525.00
Net gain ` 38.68
Since Mr. A is gaining ` 38.68 per share, he should buy the share.
Maximum price Mr. A should be ready to pay is ` 563.68 which will include incidental
expenses. So the maximum price should be ` 563.68 x 100/105 = ` 536.84
15. (i) Equilibrium price of Equity using CAPM
= 9% + 1.2(13% - 9%)
= 9% + 4.8%= 13.8%
D1 2.00(1.07) 2.14
P= = = = ` 31.47
k e - g 0.138- 0.07 0.068
(ii) New Equilibrium price of Equity using CAPM

= 9.18% + 1.3(13% - 9.18%)
= 9.18% + 4.966%= 14.146%
D1 2.00(1.10) 2.20
P= = = = ` 53.06
k e - g 0.14146 - 0.10 0.04146

= 11% + 1.3(15% - 8%)
= 11% + 5.2%= 16.20%
D1 2.00(1.10)
P= = = ` 35.48
k e - g 0.162 − 0.10
Alternatively, if all the factors are taken separately then solution will be as follows:
(i) Inflation Premium increase by 3%. This raises R X to 15.80%. Hence, new
equilibrium price will be:
2.00(1.07)
= = ` 24.32
0.158 − 0.07
(ii) Expected Growth rate decrease by 3%. Hence, revised growth rate stands at
10%:
2.00(1.10)
= = ` 57.89
0.138 − 0.10
(iii) Beta decreases to 1.3. Hence, revised cost of equity shall be:
= 9% + 1.3(13% - 9%)
= 9% + 5.2%= 14.2%
As a result, New Equilibrium price shall be:
D1 2.00(1.07)
P= = = ` 29.72
k e - g 0.142 − 0.07
D1
16. Value of share at present =
ke − g
2(1.06)
= = ` 106
0.08 − 0.06
However, if the Board implement its decision, no dividend would be payable for 3 years and
the dividend for year 4 would be ` 2.50 and growing at 7% p.a. The price of the share, in
this case, now would be:
2.50 1
P0 =  = ` 198.46
0.08 − 0.07 (1 + 0.08)3
So, the price of the share is expected to increase from ` 106 to ` 198.45 after the
announcement of the project. The investor can take up this situation as follows:
Expected market price after 3 years 2.50 ` 250.00
=
0.08 − 0.07
Expected market price after 2 years 2.50 1 ` 231.48
×
0.08 - 0.07 (1+ 0.08)
Expected market price after 1 years 2.50 1 ` 214.33

0.08 − 0.07 (1 + 0.08)2
In order to maintain his receipt at ` 2,000 for first 3 year, he would sell
10 shares in first year @ ` 214.33 for ` 2,143.30

9 shares in second year @ ` 231.48 for ` 2,083.32
8 shares in third year @ ` 250 for ` 2,000.00
At the end of 3rd year, he would be having 973 shares valued @ ` 250 each i.e.
` 2,43,250. On these 973 shares, his dividend income for year 4 would be @ ` 2.50 i.e. `
2,432.50.
So, if the project is taken up by the company, the investor would be able to maintain his
receipt of at least ` 2,000 for first three years and would be getting increased income
thereafter.
Covariance of Market Return and Security Return
17. β=
Variance of Market Return
30%
β= = 1.25
24%
Expected Return = R f + β(Rm - Rf)
= 11% + 1.25(18% - 11%) = 11% + 8.75% = 19.75%
Intrinsic Value
Year Dividend (`) PVF (19.75%,n) Present Value (`)

1 2.80 0.835 2.34
2 3.92 0.697 2.73
3 5.49 0.582 3.19
4 7.68 0.486 3.73
5 10.76 0.406 4.37
16.36
10.76(1.15)
PV of Terminal Value = =  0.406 = ` 105.77
0.1975 − 0.15
Intrinsic Value = ` 16.36 + ` 105.77 = ` 122.13
18. (i) Let P be the buyback price decided by Rahul Ltd.
Market Capitalisation after Buyback
1.1P (Original Shares – Shares Bought Back)
 27% of 100 lakhs 
= 1.1P  10 lakhs - 
 P 
= 11 lakhs  P – 27 lakhs  1.1 = 11 lakhs P – 29.7 lakhs

Again, 11 lakhs P – 29.7 lakhs
or 11 lakhs P = 210 lakhs + 29.7 lakhs
239.7
or P = = ` 21.79 per share
11
(ii) Number of Shares to be Bought Back :-
` 27 lakhs
= 1.24 lakhs (Approx.) or 123910 share
` 21.79
(iii) New Equity Shares :-
10 lakhs – 1.24 lakhs = 8.76 lakhs or 1000000 – 123910 = 876090 shares
3  10 lakhs
EPS = = ` 3.43
8.76 lakhs
Thus, EPS of Rahul Ltd., increases to ` 3.43.
19. Case (i) Required yield rate = 5%
Cash Present
Year
Flow ` DF (5%) Value `
1-5 10 4.3295 43.295
5 110 0.7835 86.185
Value of bond 129.48
Case (ii) Required yield rate = 5.1%
Cash DF Present
Year
Flow ` (5.1%) Value `
1-5 10 4.3175 43.175
5 110 0.7798 85.778
Case (iii) Required yield rate = 10%
Cash DF Present
Year
Flow ` (10%) Value `
1-5 10 3.7908 37.908
5 110 0.6209 68.299
Case (iv) Required yield rate = 10.1%
Cash DF Present
Year
Flow ` (10.1%) Value `
1-5 10 3.7811 37.811
5 110 0.6181 67.991
20. (i) Calculation of Maximum price
Bo = ` 11 × PVIFA (13%,3) + ` 100 × PVIF (13%,3)
= ` 11 × 2.361 + ` 100 × 0.693 = ` 25.97 + ` 69.30 = ` 95.27
(ii) Calculation of yield
At 12% the value = ` 11 × PVIFA (12%,3) + 100 × PVIF (12%,3)
= ` 11×2.402 + ` 100×0.712 = ` 26.42 + ` 71.20 = ` 97.62
It the bond is selling at ` 97.60 which is more than the fair value, the YTM of the
bond would be less than 13%. This value is almost equal to the amount price of `
97.60. Therefore, the YTM of the bond would be 12%.
Alternatively
( ` 100 - ` 97.60 )
` 11 +
3 = 0.1194 or 11.94% say 12%
YTM =
(` 100 + ` 97.60)
2
21. (i) Current yield = (Coupon Interest / Market Price) X 100
(10/110) X 100 = 9.09%
If current yield go up by 1% i.e. 10.09 the market price would be
10.09 = 10 / Market Price X 100
Market Price = ` 99.11
(ii) Market Price of Bond = P.V. of Interest + P.V. of Principal
= ` 1,394 + ` 8,885 = ` 10,279
22. Conversion rate is 14 shares per bond. Market price of share ` 80
Conversion Value 14 x ` 80 = ` 1120
Market price of bond = ` 1475
355
Premium over Conversion Value (` 1475- ` 1120) = x 100 = 31.7%
1120
23. If Debentures are not converted its value is as under: -
PVF @ 8 % `
Interest - ` 12 for 5 years 3.993 47.916
Redemption - ` 100 in 5th year 0.681 68.100
116.016
Value of equity shares:-
Market Price No. Total

`4 20 ` 80
`5 20 ` 100
`6 20 ` 120
Hence, unless the market price is ` 6 conversion should not be exercised.
24. (i) Stock value or conversion value of bond
12 × 20 = ` 240
(ii) Percentage of the downside risk
` 265 -` 235 ` 265 -` 235
= 0.1277 or 12.77% or = 0.1132 or 11.32%
` 235 ` 265
This ratio gives the percentage price decline experienced by the bond if the stock
becomes worthless.
(iii) Conversion Premium
Market Pr ice − Conversion Value
 100
Conversion Value
` 265 -` 240
 100 = 10.42%
` 240
(iv) Conversion Parity Price
Bond Pr ice
No. of Shares on Conversion
` 265
= ` 13.25
20
This indicates that if the price of shares rises to ` 13.25 from ` 12 the investor will
neither gain nor lose on buying the bond and exercising it. Observe that ` 1.25 (`
13.25 – ` 12.00) is 10.42% of ` 12, the Conversion Premium.
25. (i) Calculation of initial outlay:-

` (million)
a. Face value 300
Add:-Call premium 12
Cost of calling old bonds 312
b. Gross proceed of new issue 300
Less: Issue costs 6
Net proceeds of new issue 294
c. Tax savings on call premium
and unamortized cost 0.30 (12 + 9) 6.3
 Initial outlay = ` 312 million – ` 294 million – ` 6.3 million = ` 11.7 million
(ii) Calculation of net present value of refunding the bond:-
Saving in annual interest expenses ` (million)
[300 x (0.12 – 0.10)] 6.00
Less:- Tax saving on interest and amortization
0.30 x [6 + (9-6)/6] 1.95
Annual net cash saving 4.05
PVIFA (7%, 6 years) 4.766
 Present value of net annual cash saving ` 19.30 million
Less:- Initial outlay ` 11.70 million
Net present value of refunding the bond ` 7.60 million
Decision: The bonds should be refunded
26. 1. Calculation of Market price:
 Discount or premium 
Coupon int erest +  
 Years left 
YTM =
Face Value + Market value
2
Discount or premium – YTM is more than coupon rate, market price is less than Face
Value i.e. at discount.
Let x be the market price
 (1,000 - x) 
160 +  
 6 
0.17 = x = ` 960.26
1,000 + x
2
Alternatively, the candidate may attempt by

160 (PVIAF 17%,6) + 1,000 (PVIF 17%,6)
= 160 (3.589) + 1,000 (0.390) = 574.24 + 390 = 964.24
2. Duration
Year Cash flow P.V. @ 17% Proportion of Proportion of bond
bond value value x time (years)
1 160 .855 136.80 0.142 0.142
2 160 .731 116.96 0.121 0.246
3 160 .624 99.84 0.103 0.309
4 160 .534 85.44 0.089 0.356
5 160 .456 72.96 0.076 0.380
6 1160 .390 452.40 0.469 2.814
964.40 1.000 4.247
Duration of the Bond is 4.247 years
Alternatively, as per Short Cut Method
1+ YTM (1+ YTM) + t (c - YTM)
D= -
YTM [ ]
c ( 1+ YTM)t -1 + YTM
Where YTM = Yield to Maturity

c = Coupon Rate
t = Years to Maturity
1.17 1.17 + 6(0.16 − 0.17)
= -
0.17 0.16( 1.17 )6 -1 + 0.17
 
D = 4.24 years
3. Volatility
Duration 4.247 4.2422
Volatility of the bonds = = = 3.63 Or = = 3.6258
(1 + yields) 1.17 1.17
4. The expected market price if increase in required yield is by 75 basis points.

= ` 960.26  .75 (3.63/100) = ` 26.142
Hence expected market price is ` 960.26 – ` 26.142 = ` 934.118
Hence, the market price will decrease
This portion can also be alternatively done as follows

= ` 964.40  .75 (3.63/100) = ` 26.26
then the market price will be = ` 964.40 – 26.26 = ` 938.14
27. Duration of Bond X

1 1070 .909 972.63 1.000 1.000
Duration of the Bond is 1 year
Duration of Bond Y
1 80 .909 72.72 0.077 0.077
2 80 .826 66.08 0.071 0.142
3 80 .751 60.08 0.064 0.192
4 1080 .683 737.64 0.788 3.152
936.52 1.000 3.563
Duration of the Bond is 3.563 years
Let x1 be the investment in Bond X and therefore investment in Bond Y shall be (1 - x1).
Since the required duration is 2 year the proportion of investment in each of these two
securities shall be computed as follows:
2 = x1 + (1 - x1) 3.563
x1 = 0.61
Accordingly, the proportion of investment shall be 61% in Bond X and 39% in Bond Y
respectively.
Amount of investment
Bond X Bond Y
PV of ` 1,00,000 for 2 years @ 10% x 61% PV of ` 1,00,000 for 2 years @ 10% x 39%
= ` 1,00,000 (0.826) x 61% = ` 1,00,000 (0.826) x 39%
= ` 50,386 = ` 32,214
No. of Bonds to be purchased No. of Bonds to be purchased
= ` 50,386/` 972.73 = 51.79 i.e. approx. 52 = ` 32,214/` 936.52 = 34.40 i.e. approx. 34
bonds bonds
Note: The investor has to keep the money invested for two years. Therefore, the investor
can invest in both the bonds with the assumption that Bond X will be reinvested for another
one year on same returns.
Further, in the above computation, Modified Duration can also be used instead of Duration.
28. Let the issue price be X
By the terms of the issue of the T-bills:
100 - x 365
6% =   100
x 91
6 × 91 × x
= (100 - x)
36,500
0.01496 x = 100 – x
100
x= = ` 98.53
1.01496
29. (i) Pre-tax Income required on investment of ` 20,00,000
Let the period of Investment be ‘P’ and return required on investment ` 1,00,000
(` 20,00,000 x 5%)
Accordingly,
9 P
(` 20,00,000 x x ) – ` 50,000 = ` 1,00,000
100 12
P = 10 months
(ii) Break-Even its investment expenditure
9 P
(` 20,00,000 x x ) – ` 50,000 = 0
100 12
P = 3.33 months
30. The company had issued commercial paper worth `10 crores
No. of days Involves = 91 days
Interest rate applicable = 12.04 % p.a.
91 Days
Interest for 91 days = 12.04%× = 3.002%
365Days
3.002
= or ` 10 crores x = ` 29,14,507
100 + 3.002
= or ` 29.14507 Lakhs
 Net amount received at the time of issue:- ` 10.00 Crores – ` 0.29151 Crores = `
9.70849 Crores
Rs.10 Crores
Price = = ` 9.70855 Crores
 91 Days 
 1+ 12.04% × 
 365 Days 
31. (i) Dirty Price

= Clean Price + Interest Accrued
10 262
= 99.42 + 100 × × = 106.70
100 360
(ii) First Leg (Start Proceed)
Dirty Price 100 - Initial Margin
= Nominal Value x ×
100 100
106.70 100 - 2
= `8,00,00,000 x × = `8,36,52,800
100 100
No. of days
Second Leg (Repayment at Maturity) = Start Proceed x (1 + Repo rate × )
360
14
= ` 8,36,52,800 x (1+ 0.0565 × ) = ` 8,38,36,604
360
5
PORTFOLIO MANAGEMENT
LEARNING OUTCOMES
After going through the chapter student shall be able to understand

❑ Activities in Portfolio Management
❑ Objectives of Portfolio Management
❑ Phases of Portfolio Management
(1) Security Analysis
(2) Portfolio Analysis
(3) Portfolio Selection
(4) Portfolio Revision
(5) Portfolio Evaluation
❑ Portfolio Theories
(1) Traditional Approach
(2) Modern Approach (Markowitz Model or Risk-Return Optimization)
❑ Risk Analysis
(1) Types of Risk
(2) Diversion of Risk
(3) Risk & Return
(4) Portfolio Analysis

❑ Markowitz Model of Risk-Return Optimization
❑ Capital Market Theory
❑ Sharpe Index Model (Single Index Model)
❑ Capital Asset Pricing Model (CAPM)
❑ Arbitrage Pricing Theory Model (APT)
❑ Portfolio Evaluation Methods
❑ Sharpe’s Optimal Portfolio
❑ Formulation of Portfolio Strategy
❑ Portfolio Revision and Rebalancing
❑ Asset Allocation Strategies
❑ Fixed Income Portfolio
❑ Alternative Investment Strategies in context of Portfolio Management
1. INTRODUCTION
Investment in the securities such as bonds, debentures and shares etc. is lucrative as well as
exciting for the investors. Though investment in these securities may be rewarding, it is also fraught
with risk. Therefore, investment in these securities requires a good amount of scientific and analytical
skill. As per the famous principle of not putting all eggs in the same basket, an investor never invests
his entire investable funds in one security. He invests in a well diversified portfolio of a number of
securities which will optimize the overall risk-return profile. Investment in a portfolio can reduce risk
without diluting the returns. An investor, who is expert in portfolio analysis, may be able to generate
trading profits on a sustained basis.
Every investment is characterized by return and risk. The concept of risk is intuitively understood by
investors. In general, it refers to the possibility of the rate of return from a security or a portfolio of
securities deviating from the corresponding expected/average rate and can be mea sured by the
standard deviation/variance of the rate of return.
PORTFOLIO MANAGEMENT 5.3
How different type of Investors react in different situations
Source: www.missiassaugahsale.com
1.1 Activities in Portfolio Management

The following three major activities are involved in the formation of an Optimal Portfolio suitable for
any given investor:
(a) Selection of securities.
(b) Construction of all Feasible Portfolios with the help of the selected securities.
(c) Deciding the weights/proportions of the different constituent securities in the portfolio so that
it is an Optimal Portfolio for the concerned investor.
The activities are directed to achieve an Optimal Portfolio of investments commensurate with the
risk appetite of the investor.
1.2 Objectives of Portfolio Management
Some of the important objectives of portfolio management are:
(i) Security/Safety of Principal Amount: Security not only involves keeping the principal sum
intact but also its purchasing power.
(ii) Stability of Income: To facilitate planning more accurately and systematically the
reinvestment or consumption of income.
(iii) Capital Growth: It can be attained by reinvesting in growth securities or through purchase of
growth securities.
(iv) Marketability i.e. the case with which a security can be bought or sold: This is essential
for providing flexibility to investment portfolio.
(v) Liquidity i.e. nearness to money: It is desirable for the investor so as to take advantage of
attractive opportunities upcoming in the market.
(vi) Diversification: The basic objective of building a portfolio is to reduce the risk of loss of
capital and/or income by investing in various types of securities and over a wide range of
industries.
(vii) Favourable Tax Status: The effective yield an investor gets from his investment depends on
tax to which it is subjected to. By minimising the tax burden, yield can be effectively improved.
2. PHASES OF PORTFOLIO MANAGEMENT

Portfolio management is a process and broadly it involves following five phases and each phase is
an integral part of the whole process and the success of portfolio management depends upon the
efficiency in carrying out each of these phases.
2.1 Security Analysis
The securities available to an investor for investment are numerous in number and of various types.
The securities are normally classified on the basis of ownership of securities such as equity shares,
preference shares, debentures and bonds, In recent times a number of new securities with innovative
features are available in the market e.g. Convertible Debentures, Deep Discount Bonds, Zero
Coupon Bonds, Flexi Bonds, Floating Rate Bonds, Global Depository Receipts, Euro-currency
Bonds, etc. are some examples of these new securities. Among this vast group of securities, an
investor has to choose those ones which he considers worthwhile to be included in his investment
portfolio. This requires a detailed analysis of the all securities available for making investment.
Security analysis constitutes the initial phase of the portfolio formation process and consists in
examining the risk-return characteristics of individual securities and also the correlation among
them. A simple strategy in securities investment is to buy under-priced securities and sell overpriced
securities. But the basic problem is how to identify under-priced and overpriced securities and this
is what security analysis is all about.
As discussed in the chapter of Security Analysis, there are two alternative approaches to analyse
any security viz. Fundamental Analysis and Technical Analysis. They are based on different
premises and follow different techniques. Fundamental analysis, the older of the two approaches,
concentrates on the fundamental factors affecting the company such as
❑ the EPS of the company,
❑ the dividend pay-out ratio,
❑ the competition faced by the company,
❑ the market share, quality of management, etc.
❑ fundamental factors affecting the industry to which the company belongs.
The Fundamental Analyst compares this intrinsic value (true worth of a security based on its
fundamentals) with the current market price. If the current market price is higher than the intrinsic
value, the share is said to be overpriced and vice versa. This mispricing of securities gives an
opportunity to the investor to acquire the share or sell off the share profitably. An intelligent investor
would buy those securities which are under-priced and sell those securities which are overpriced.
Thus it can be said that fundamental analysis helps to identify fundamentally strong companies
whose shares are worthy to be included in the investor's portfolio.
The second approach to security analysis is ‘Technical Analysis’. As per this approach the share
price movements are systematic and exhibit certain consistent patterns. Therefore, properly studied
past movements in the prices of shares help to identify trends and patterns in security prices and
efforts are made to predict the future price movements by looking at the patterns of the immediate
past. Thus Technical Analyst concentrates more on price movements and ignores the fundamentals
of the shares.
In order to construct well diversified portfolios, so that Unsystematic Risk can be eliminated or
substantially mitigated, an investor will like to select securities across diverse industry sectors which
should not have strong positive correlation among themselves.
The Random Walk Theory holds that the share price movements are random and not systematic.
Consequently, neither Fundamental Analysis nor Technical Analysis is of value in generating trading
gains on a sustained basis. The Efficient Market Hypothesis (EMH) does not subscribe to the belief
that it is possible to book gains in the long term on a sustained basis from trading in the stock market.
Markets, though becoming increasingly efficient everywhere with the passage of time, are never
perfectly efficient. So, there are opportunities all the time although their durations are decreasing
and only the smart investors can look forward to booking gains consistently out of stock market
deals.
2.2 Portfolio Analysis
Once the securities for investment have been identified, the next step is to combine these to form a
suitable portfolio. Each such portfolio has its own specific risk and return characteristics which are
not just the aggregates of the characteristics of the individual securities constituting it. The return
and risk of each portfolio can be computed mathematically based on the Risk-Return profiles for the
constituent securities and the pair-wise correlations among them.
From any chosen set of securities, an indefinitely large number of portfolios can be constructed by
varying the fractions of the total investable resources allocated to each one of them. All such
portfolios that can be constructed out of the set of chosen securities are termed as Feasible
Portfolios. Detailed discussion on Risk- Return concept has been covered later in this chapter.
2.3 Portfolio Selection
The goal of a rational investor is to identify the Efficient Portfolios out of the whole set of Feasible
Portfolios mentioned above and then to zero in on the Optimal Portfolio suiting his risk appetite. An
Efficient Portfolio has the highest return among all Feasible Portfolios having same or lower Risk or
has the lowest Risk among all Feasible Portfolios having same or higher Return. Harry Markowitz’s
portfolio theory (Modern Portfolio Theory) outlines the methodology for locating the Optimal Portfolio
for an investor out of efficient portfolios. Detailed discussion on Markowitz’s Portfolio Theory has
been covered later in this chapter.
2.4 Portfolio Revision
Once an optimal portfolio has been constructed, it becomes necessary for the investor to constantly
monitor the portfolio to ensure that it does not lose it optimality. Since the economy and financial
markets are dynamic in nature, changes take place in these variables almost on a daily basis and
securities which were once attractive may cease to be so with the passage of time. New securities
with expectations of high returns and low risk may emerge. In light of these developments in the
market, the investor now has to revise his portfolio. This revision leads to addition (purchase) of
some new securities and deletion (sale) of some of the existing securities from the portfolio. The
nature of securities and their proportion in the portfolio changes as a result of the revision.
This portfolio revision may also be necessitated by some investor-related changes such as
availability of additional funds for investment, change in risk appetite, need of cash for other
alternative use, etc.
Portfolio revision is not a casual process to be taken lightly and needs to be carried out with care,
scientifically and objectively so as to ensure the optimality of the revised portfolio. Hence, in the
entire process of portfolio management, portfolio revision is as important as portfolio analysis and
selection.
2.5 Portfolio Evaluation
This process is concerned with assessing the performance of the portfolio over a selected period of
time in terms of return and risk and it involves quantitative measurement of actual return realized
and the risk borne by the portfolio over the period of investment. The objective of constructing a
portfolio and revising it periodically is to maintain its optimal risk return characteristics. Various types
of alternative measures of performance evaluation have been developed for use by inv estors and
portfolio managers.
This step provides a mechanism for identifying weaknesses in the investment process and for
improving these deficient areas.
It should however be noted that the portfolio management process is an ongoing process. It starts
with security analysis, proceeds to portfolio construction, and continues with portfolio -revision and
end with portfolio evaluation. Superior performance is achieved through continual re finement of
portfolio management skill. Detailed discussion on the techniques of Portfolio Evaluation has been
covered later in this chapter.
3. PORTFOLIO THEORIES
Portfolio theory forms the basis for portfolio management. Portfolio management deals wit h the
selection of securities and their continuous shifting in the portfolio to optimise returns to suit the
objectives of an investor. This, however, requires financial expertise in selecting the right mix of
securities in changing market conditions to get the best out of the stock market. In India as well as
in a number of Western countries, portfolio management service has assumed the role of a
specialised service and a number of professional investment bankers/fund managers compete
aggressively to provide the best options to high net-worth clients, who have little time to manage
their own investments. The idea is catching on with the growth of the capital market and an
increasing number of people want to earn profits by investing their hard-earned savings in a planned
manner.
A portfolio theory guides investors about the method of selecting and combining securities that will
provide the highest expected rate of return for any given degree of risk or that will expose the investor
to the lowest degree of risk for a given expected rate of return. Portfolio theory can be discussed
under the following heads:
3.1 Traditional Approach
The traditional approach to portfolio management concerns itself with the investor, definition of
portfolio objectives, investment strategy, diversification and selection of individual investment as
detailed below:
(i) Investor's study includes an insight into his –
(a) age, health, responsibilities, other assets, portfolio needs;
(b) need for income, capital maintenance, liquidity;
(c) attitude towards risk; and
(d) taxation status;
(ii) Portfolio objectives are defined with reference to maximising the investors' wealth which is
subject to risk. The higher the level of risk borne, the more the expected returns.
(iii) Investment strategy covers examining a number of aspects including:
(a) Balancing fixed interest securities against equities;
(b) Balancing high dividend payout companies against high earning growth companies as
required by investor;
(c) Finding the income of the growth portfolio;
(d) Balancing income tax payable against capital gains tax;
(e) Balancing transaction cost against capital gains from rapid switching; and
(f) Retaining some liquidity to seize upon bargains.
(iv) Diversification reduces volatility of returns and risks and thus adequate equity diversification
is sought. Balancing of equities against fixed interest bearing securities is also sought.
(v) Selection of individual investments is made on the basis of the following principles:
(a) Methods for selecting sound investments by calculating the true or intrinsic value of a
share and comparing that value with the current market value (i.e. by following the
fundamental analysis) or trying to predict future share prices from past price
movements (i.e., following the technical analysis);
(b) Expert advice is sought besides study of published accounts to predict intrinsic value;
(c) Inside information is sought and relied upon to move to diversified growth companies,
switch quickly to winners than loser companies;
(d) Newspaper tipsters about good track record of companies are followed closely;
(e) Companies with good asset backing, dividend growth, good earning record, high
quality management with appropriate dividend paying policies and leve rage policies
are traced out constantly for making selection of portfolio holdings.
In India, most of the share and stock brokers follow the above traditional approach for selecting a
portfolio for their clients.
The Traditional Approach suggests that one should not put all money in one basket, instead an
investor should diversify by investing in different securities and assets. As long as an investor invests
in different assets and securities, he shall get the advantage of diversification. Markowitz questi oned
this wisdom of the Traditional Approach and proved that putting money in particular kinds of
securities or assets will give the investor advantage of diversification. Therefore, one should not go
blindly picking up securities and assets to make portfolio.
3.2 Modern Approach (Markowitz Model or Risk-Return Optimization)

Originally developed by Harry Markowitz in the early 1950's, Portfolio Theory - sometimes referred
to as Modern Portfolio Theory - provides a logical/mathematical framework in which investors can
optimise their risk and return. The central plank of the theory is that diversification through portfolio
formation by adding securities whose returns are having low correlation or negative correlation into
portfolio can reduce risk, and second, one can get higher return by taking higher risk.
Harry Markowitz is regarded as the father of Modern Portfolio Theory. According to him, investors
are mainly concerned with two properties of an asset: risk and return . The essence of his theory is
that risk of an individual asset hardly matters to an investor. What really matters is the contribution
it makes to the investor's overall risk. By turning his principle into a useful technique for selecting
the right portfolio from a range of different assets, he developed the 'Mean Variance Analysis' in
1952.
We shall discuss this theory in detail later in this chapter.
4. RISK ANALYSIS
Before proceeding further it will be better if the concept of risk and return is discussed. A person
makes an investment in the expectation of getting some return in the future, but the future is
uncertain and so is the uncertain future return. It is this uncertainty associated with the returns from
an investment that introduces risk for an investor.
It is important here to distinguish between the expected return and the realized return from an
investment. The expected future return is what an investor expects to get from his investment. On
the other hand, the realized return is what an investor actually obtains from his investment at the
end of the investment period. The investor makes the investment decision based on the expected
return from the investment. However, the actual return realized from the investment may not
correspond to the expected return. This possible variation of the actual return from the expected
return is termed as risk. If actual realizations correspond to expectations exactly, there would be no
risk. Risk arises where there is a probability of variation between expectations and realizations with
regard to an investment.
Thus, risk arises from the variability in returns. An investment whose returns are fairly stable is
considered to be a low-risk investment, whereas an investment whose returns fluctuate significantly
is considered to be a highly risky investment. Government securities whose returns are fairly stable
and which are free from default are considered to possess low risk whereas equity shares whose
returns are likely to fluctuate widely around their mean are considered risky investments.
The essence of risk in an investment is the variation in its returns. This variation in returns is caused
by a number of factors. These factors which produce variations in the returns from an investment
constitute different types of of risk.
4.1 Types of Risk

Let us consider the risk in holding equity securities. The elements of risk may be broadly classified
into two groups as shown in the following diagram.
The first group i.e. systematic risk comprises factors that are external to a company (macro in nature)
and affect a large number of securities simultaneously. These are mostly uncontrollable in nature.
The second group i.e. unsystematic risk includes those factors which are internal to companies
(micro in nature) and affect only those particular companies. These are controllable to a great extent.
The total variability in returns of a security is due to the total risk of that security. Hence,
Total risk = Total Systematic risk + Total Unsystematic risk
4.1.1 Systematic Risk
Due to dynamic nature of an economy, the changes occur in the economic, political and social
conditions constantly. These changes have an influence on the performance of companies and
thereby on their stock prices but in varying degrees. For example, economic and political instability
adversely affects all industries and companies. When an economy moves into recession, corp orate
profits will shift downwards, and stock prices of most companies may decline. Thus, the impact of
economic, political and social changes is system-wide and that portion of total variability in security
returns caused by such macro level factors is referred to as systematic risk. Systematic risk can be
further subdivided into interest rate risk, market risk and purchasing power risk.
(i) Interest Rate Risk: This arises due to variability in the interest rates from time to time and its
impact on security prices. A change in the interest rates establishes an inverse relationship with the
price of security i.e. price of securities tends to move inversely with change in rate of interest, long
term securities show greater variability in the price with respect to interest rate changes than short
term securities.
(ii) Purchasing Power Risk: It is also known as inflation risk, as it also emanates from the very
fact that inflation affects the purchasing power adversely. Nominal return contains both the real
return component and an inflation premium in a transaction involving risk of the above type to
compensate for inflation over an investment holding period. Inflation rates vary over time and
investors are caught unaware when rate of inflation changes unexpectedly causing erosion in the
value of realised rate of return and expected return.
Purchasing power risk is more in inflationary conditions especially in respect of bonds and fixed
income securities. It is not desirable to invest in such securities during inflationary periods.
Purchasing power risk is however, less in flexible income securities like equity shares or common
stock where rise in dividend income off-sets increase in the rate of inflation and provides advantage
of capital gains.
(iii) Market risk: This is a type of systematic risk that affects prices of a share that moves up or
down consistently for some time periods in line with other shares in the mar ket. A general rise in
share prices is referred to as a bullish trend, whereas a general fall in share prices is referred to as
a bearish trend. In other words, the share market moves between the bullish phase and the bearish
phase. The market movements can be easily seen in the movement of share price indices such as
the BSE Sensitive Index, BSE National Index, NSE Index etc.
4.1.2 Unsystematic Risk
Sometimes the return from a security of any company may vary because of certain factors particular
to this company. Variability in returns of the security on account of these factors (micro in nature),
is known as unsystematic risk. It should be noted that this risk is in addition to the systematic risk
affecting all the companies. Unsystematic risk can be further subdivided into business risk and
financial risk.
(i) Business Risk: Business risk emanates variability in the operating profits of a company –
higher the variability in the operating profits of a company, higher is the business ri sk. Such a risk
can be measured using operating leverage.
(ii) Financial Risk: It arises due to presence of debt in the capital structure of the company. It is
also known as leveraged risk and expressed in terms of debt-equity ratio. Excess of debt vis-à-vis
equity in the capital structure indicates that the company is highly geared and hence, has higher
financial risk. Although a leveraged company's earnings per share may be more but dependence on
borrowings exposes it to the risk of winding-up for its inability to honour its commitments towards
lenders/creditors. This risk is known as leveraged or financial risk of which investors should be aware
of and portfolio managers should be very careful.
4.2 Diversion of Risk
As discussed above, the total risk of an individual security consists of two risks systematic risk and
unsystematic risk. It should be noted that by combining many securities in a portfolio the
unsystematic risk can be avoided or diversified which is attached to any particular security. The
following diagram depicts how the risk can be reduced with the increase in the number of securities.
From the above diagram it can be seen that total risk is reducing with the increase in the number of
securities in the portfolio. However, ultimately when the size of the portfolio reaches certain limit, it
will contain only the systematic risk.
4.3 Risk & Return
It is very common that an intelligent investor would attempt to anticipate the kind of risk that he/she
is likely to face and would also attempt to estimate the extent of risk associated with different
investment proposals. In other words an attempt is made by him/her to measure or quantify the risk
of each investment under consideration before making the final selection. Thus quantification of risk
is necessary for analysis of any investment.
As risk is attached with return its risk cannot be measured without reference to return. The return,
in turn, depends on the cash inflows to be received from the investment. Let us take an example of
purchase of a share. With an investment in an equity share, an investor expects to receive future
dividends declared by the company. In addition, he expects to receive capital gain in the form of
difference between the selling price and purchase price, when the share is finally sold.
Suppose a share of X Ltd. is currently selling at ` 12.00. An investor who is interested in the share
anticipates that the company will pay a dividend of ` 0.50 in the next year. Moreover, he expects
to sell the share at ` 17.50 after one year. The expected return from the investment in share will be
as follows:
Forecasted dividend + Forecasted end of the period stock price
R= -1
Initial investment
` 0.50 + ` 17.50
R= - 1 = 0.5 or 50 per cent
` 12.00
It is important to note that here the investor expects to get a return of 50 per cent in the future, which
is uncertain. It might be possible that the dividend declared by the company may turn out to be either
more or less than the figure anticipated by the investor. Similarly, the selling price of the share may
be less than the price expected by the investor at the time of investment. It may sometimes be even
more. Hence, there is a possibility that the future return may be more than 50 per cent or less than
50 per cent. Since the future is uncertain the investor has to consider the probability of several other
possible returns. The expected returns may be 20 per cent, 30 per cent, 50 per cent, 60 per cent or
70 per cent. The investor now has to assign the probability of occurrence of these possible
alternative returns as given below:
Possible returns (in per cent) Probability of occurrence

Xi p(Xi)
20 0.20
30 0.20
50 0.40
60 0.10
70 0.10
The above table gives the probability distribution of possible returns from an investment in shares.
Such distribution can be developed by the investor with the help of analysis of past data and
modifying it appropriately for the changes he expects to occur in a future period of time.
With the help of available probability distribution two statistical measures one expected return and
the other risk of the investment can be calculated.
4.3.1 Expected Return
The expected return of the investment is the probability weighted average of all the possible returns.
If the possible returns are denoted by Xi and the related probabilities are p(Xi) the expected return
may be represented as X and can be calculated as:
n
X= ∑x i p(X i )
i=1
It is the sum of the products of possible returns with their respective probabilities.
The expected return of the share in the example given above can be calculated as shown below :
Calculation of Expected Return
Possible returns Probability

Xi p(Xi) Xi p(Xi)
0.20 0.20 0.04
0.30 0.20 0.06
0.40 0.40 0.16
0.50 0.10 0.05
0.60 0.10 0.06
n
∑x i p(X i) 0.37
i=1
Hence the expected return is 0.37 i.e. 37%

4.3.2 Risk
As risk is attached with every return hence calculation of only expected return is not sufficient for
decision making. Therefore risk aspect should also be considered along with the expected return.
The most popular measure of risk is the variance or standard deviation of the probability distribution
of possible returns.
Variance of each security is generally denoted by σ 2 and is calculated by using the following formula:
n
σ2 = ∑ [(X - X)
i
2
p(X i )]
i=1
Continuing our earlier example the following table provides calculations required to calculate the risk
i.e. Variance or Standard Deviation (SD).
Possible Probability Deviation Deviation squared Product
returns Xi p(Xj) (Xi - X ) (Xi - X )2 (Xi - X )2 p(Xj)
0.20 0.20 -0.17 0.0289 0.00578

0.30 0.20 -0.07 0.0049 0.00098
0.40 0.40 0.03 0.0009 0.00036
0.50 0.10 0.13 0.0169 0.00169
0.60 0.10 0.23 0.0529 0.00529
Var (σ2) 0.0141
Variance = 0.0141
Standard Deviation of the return will be the positive square root of the variance and is generally
represented by σ. Accordingly, the standard deviation of return in the above example will be
0.0141 = 0.1187 i.e. 11.87%.
The basic purpose to calculate the variance and standard deviation is to measure the extent of
variability of possible returns from the expected return. Several other measures such as range, semi -
variance and mean absolute deviation can also be used to measure risk, but standard deviation has
been the most popularly accepted measure.
The method described above is widely used for assessing risk.
The standard deviation or variance, however, provides a measure of the total risk associated with a
security. As we know, the total risk comprises two components, namely systematic risk and
unsystematic risk. Unsystematic risk is the risk specific or unique to a company. Unsystematic risk
associated with the security of a particular company can be eliminated/reduced by combining it with
another security having negative correlation. This process is known as diversification of
unsystematic risk. As a means of diversification the investment is spread over a group of securities
with different characteristics. This collection of diverse securities is called a Portfolio.
As unsystematic risk can be reduced or eliminated through diversification, it is not very important for
an investor to consider. The risk that is relevant in investment decisions is the systematic risk
because it is not diversifiable. Hence, the main interest of the investor lies in the measurement of
systematic risk of a security.
4.3.3 Measurement of Systematic Risk
As discussed earlier, systematic risk is the variability in security returns caused by changes in the
economy or the market and all securities are affected by such changes to some extent. Some
securities exhibit greater variability in response to market changes and some may exhibit less
response. Securities that are more sensitive to changes in factors are said to have higher systematic
risk. The average effect of a change in the economy can be represented by the change in the stock
market index. The systematic risk of a security can be measured by relating that security’s variability
vis-à-vis variability in the stock market index. A higher variability would indicate higher systematic
risk and vice versa.
The systematic risk of a security is measured by a statistical measure which is called Beta (β). The
main input data required for the calculation of beta of any security are the historical data of returns
of the individual security and corresponding return of a representative market return (stock market
index). There are two statistical methods i.e. correlation method and the regression method, which
can be used for the calculation of Beta.
4.3.3.1 Correlation Method : Using this method beta (β) can be calculated from the historical data
of returns by the following formula:
rim σ i
βi =
σm
Where
rim = Correlation coefficient between the returns of the stock i and the returns of the market
index.
σ i = Standard deviation of returns of stock i
σ m = Standard deviation of returns of the market index.
4.3.3.2 Regression Method : The regression model is based on the postulation that there exists a
linear relationship between a dependent variable and an independent variable. The model helps to
calculate the values of two constants, namely alfa (α) and beta (β). β measures the change in the
dependent variable in response to unit change in the independent variable, while α measures the
value of the dependent variable even when the independent variable has zero value. The form ula of
the regression equation is as follows:
Y = α + βX
where
Y = Dependent variable
X = Independent variable
α and β are constants.
α = Y - βX
The formula used for the calculation of α and β are given below.
n ∑ XY - (∑ X)(∑ Y)
β=
n∑ X (∑ X)
2 2
where
n = Number of items.
Y = Dependent variable scores.
X = Independent variable scores.
For the purpose of calculation of β, the return of the individual security is taken as the dependent
variable and the return of the market index is taken as the independent variable. The regression
equation is represented as follows:
R i = α + β i Rm +  i
where
Ri = Return of the individual security.

Rm = Return of the market index.
α = Estimated return of the security when the market is stationary.
βi = Change in the return of the individual security in response to unit change in
the return of the market index. It is, thus, the measure of systematic risk of a security.
i = Error term in the model
Here it is very important to note that a security can have betas that are positive, negative or zero.
• Positive Beta- indicates that security’s return is dependent on the market return and moves
in the direction in which market moves.
• Negative Beta- indicates that security’s return is dependent on the market return but moves
in the opposite direction in which market moves.
• Zero Beta- indicates that security’s return is independent of the market return.
Further as beta measures the volatility of a security’s returns relative to the market, the larger the
beta, the more volatile the security.
• A beta of 1.0 indicates that a security has risk as that of the market.
• A stock with beta greater than 1.0 has above average risk i.e. its returns would be more
volatile than the market returns. For example, when market returns move up by 6%, a stock
with beta of 2 would find its returns moving up by 12% (i.e. 6% x 2). Similarly, decline in
market returns by 6% would produce a decline of 12% (i.e. 6% x 2) in the return of that
security.
• A stock with beta less than 1.0 would have below market risk. Variability in its returns would
be less than the market variability.
Beta is calculated from historical data of returns to measure the systematic risk of a security. It is a
historical measure of systematic risk. In using this beta for investment decision making, the investor
is assuming that the relationship between the security variability and market variability will continue
to remain the same in future also.
4.4 Portfolio Analysis
Till now we have discussed the risk and return of a single security. Let us now discuss the return
and risk of a portfolio of securities.
4.4.1 Portfolio Return
For a portfolio analysis an investor first needs to specify the list of securities eligible for selection or
inclusion in the portfolio. Then he has to generate the risk-return expectations for these securities.
The expected return for the portfolio is expressed as the mean of its rates of return over the time
horizon under consideration and risk for the portfolio is the variance or standard deviation of these
rates of return around the mean return.
The expected return of a portfolio of assets is simply the weighted average of the returns of the
individual securities constituting the portfolio. The weights to be applied for calculation of the portfolio
return are the fractions of the portfolio invested in such securities.
Let us consider a portfolio of two equity shares A and B with expected returns of 16 per cent and 22
per cent respectively.
The formula for the calculation of expected portfolio return may be expressed as shown below:
n
rp = ∑x i r i
i=1
r p = Expected return of the portfolio.
Xi = Proportion of funds invested in security i

r i = Expected return of security i.
n = Number of securities in the portfolio.

If 40 per cent of the total funds is invested in share A and the remaining 60 per cent in share B, then
the expected portfolio return will be:
Return on the portfolio = (0.40 x 16) + (0.60 x 22) = 19.6 per cent
4.4.2 Portfolio Risk
As discussed earlier, the variance of return and standard deviation of return are statistical measures
that are used for measuring risk in investment. The variance of a portfolio can be written down as
the sum of 2 terms, one containing the aggregate of the weighted variances of the constituent
securities and the other containing the weighted co-variances among different pairs of securities.
Covariance (a statistical measure) between two securities or two portfolios or a security and a portfolio
indicates how the rates of return for the two concerned entities behave relative to each other.
The covariance between two securities A and B may be calculated using the following formula:
COVAB =
 [R A - R A ][RB - RB ]
N
where
COVAB = Covariance between A and B
RA = Return of security A
RB = Return of security B
R A = Expected or mean return of security A
RB = Expected or mean return of security B
N = Number of observations.
The calculation of covariance can be understood with the help of following table:
Calculation of Covariance
Deviation Deviation
Year RX Rx - R x RY RY - R Y [R x - R x ][R y - R y ]
1 11 -4 18 5 -20
2 13 -2 14 1 -2
3 17 2 11 -2 -4
4 19 4 9 -4 -16
Rx = 15 Ry =13 -42
n
∑[R x - R x ] [R y - R y ]
- 42
i=1
Cov xy = = = -10.5
n 4
From the above table it can be seen that the covariance is a measure of how returns of two securities
move together. In case the returns of the two securities move in the same direction consistently the
covariance is said to be positive (+). Contrarily, if the returns of the two securities move in opposite
directions consistently the covariance would be negative (-). If the movements of returns are
independent of each other, covariance would be close to zero (0).
The coefficient of correlation is expressed as:
Cov AB
rAB =
 A B
where
rAB = Coefficient of correlation between A and B
CovAB = Covariance between A and B
σA= Standard deviation of A
σB = Standard deviation of B
It may be noted on the basis of above formula the covariance can be expressed as the product of
correlation between the securities and the standard deviation of each of the s ecurities as shown
below:
CovAB = σA σB rAB
It is very important to note that the correlation coefficients may range from -1 to 1.
• A value of -1 indicates perfect negative correlation between the two securities’ returns.
• A value of +1 indicates a perfect positive correlation between them.
• A value of zero indicates that the returns are independent.
The calculation of the variance (or risk) of a portfolio is not simply a weighted average of the variances
of the individual securities in the portfolio as in the calculation of the return of portfolio. The variance
of a portfolio with only two securities in it can be calculated with the following formula.
 p2 = x 12 12 + x 22  22 + 2x 1 x 2 (r12 1 2 )
where
p2 = Portfolio variance.
x1 = Proportion of funds invested in the first security.
x2 = Proportion of funds invested in the second security (x1+x2 = 1).
 12 = Variance of first security.
 22 = Variance of second security.
 1 = Standard deviation of first security.
2 = Standard deviation of second security.
r12 = Correlation coefficient between the returns of the first and second securities.
As the standard deviation is the square root of the variance the portfolio standard deviation can be
obtained by taking the square root of portfolio variance.
Let us take an example to understand the calculation of portfolio variance and portfolio standard
deviation. Two securities A and B generate the following sets of expected returns, standard
deviations and correlation coefficient:
A B
r= 20% 25%
σ= 50% 30%
rab= -0.60
Now suppose a portfolio is constructed with 40 per cent of funds invested in A and the remaining 60
per cent of funds in B (i.e. P = 0.4A + 0.6B).
Using the formula of portfolio return the expected return of the portfolio will be:
RP= (0.40 x 20) + (0.60 x 25) = 23%
And the Variance and Standard Deviation of the portfolio will be:
Variance
σp 2 = (0.40)2 (50)2 + (0.60)2 (30)2 + 2(0.40)(0.60)(- 0.60)(50)(30) = 400 + 324 - 432 = 292
Standard deviation
σp = 292 = 17.09 per cent.
The return and risk of a portfolio depends on following two sets of factors:
(a) Returns and risks of individual securities and the covariance between securities forming the
portfolio
(b) Proportion of investment in each of securities.
As the first set of factors is parametric in nature for the investor in the sense that he has no control
over the returns, risks and co-variances of individual securities. The second set of factors is choice
factor or variable for the investors in the sense that they can choose the proportions of each security
in the portfolio.
4.4.3 Reduction or Dilution of Portfolio Risk through Diversification
The process of combining more than one security in to a portfolio is known as diversification. The
main purpose of this diversification is to reduce the total risk by eliminating or substantially mitigating
the unsystematic risk, without sacrificing portfolio return. As shown in the example mentioned above,
diversification has helped to reduce risk. The portfolio standard deviation of 17.09% is lower than
the standard deviation of either of the two securities taken separately which were 50% and 30%
respectively. Incidentally, such risk reduction is possible even when the two constituent securities
are uncorrelated. In case, however, these have the maximum positive correlation between them, no
reduction of risk can be achieved.
In order to understand the mechanism and power of diversification, it is necessary to consider the
impact of covariance or correlation on portfolio risk more closely. We shall discuss following three
cases taking two securities in the portfolio:
(a) Securities’ returns are perfectly positively correlated,
(b) Securities’ returns are perfectly negatively correlated, and
(c) Securities’ returns are not correlated i.e. they are independent.
4.4.3.1 Perfectly Positively Correlated : In case two securities returns are perfectly positively
correlated the correlation coefficient between these securities will be +1 and the returns of these
securities then move up or down together.
The variance of such portfolio can be calculated by using the following formula:
 p2 = x 12 12 + x 22  22 + 2x 1 x 2 r12  1 2
As r12 = 1, this may be rewritten as:

2 2 2 2 2
 = x  + x  + 2x x  
p 1 1 2 2 1 2 1 2
or
 = (x 1  1 + x 2  2 )
2 2
p
Hence Standard Deviation will become

 p = x 1 1 + x 2  2
In other words this is simply the weighted average of the standard deviations of the individual
securities.
Taking the above example we shall now calculate the portfolio standard deviation when correlation
coefficient is +1.
Standard deviation of security A = 40%
Standard deviation of security B = 25%
Proportion of investment in A = 0.4
Proportion of investment in B = 0.6
Correlation coefficient = +1.0
Portfolio standard deviation maybe calculated as:
σp = (0.4) (40) + (0.6) (25) = 31
Thus it can be seen that the portfolio standard deviation will lie between the standard deviations of
the two individual securities. It will vary between 40 and 25 as the proportion of investment in each
security changes.
Now suppose, if the proportion of investment in A and B are changed to 0.75 and 0.25 respectively;
portfolio standard deviation of the portfolio will become:
σp = (0.75) (40)+ (0.25) (25) = 36.25
It is important to note that when the security returns are perfectly positively correlated, diversification
provides only risk averaging and no risk reduction because the portfolio risk cannot be reduced
below the individual security risk. Hence, reduction of risk is not achieved when the constituent
securities’ returns are perfectly positively correlated.
4.4.3.2 Perfectly Negatively Correlated : When two securities’ returns are perfectly negatively
correlated, two returns always move in exactly opposite directions and correlation coefficient
between them becomes -1. The variance of such negatively correlated portfolio may be calculated
as:
p2 = x12 12 + x 22 22 − 2x1x 2 ( r12 12 )
As r12 = -1, this may be rewritten as:
σ p2 = (x1σ1 - x 2σ 2 )2

σp = x1σ1 - x 2σ 2
coefficient is -1.
σp = (0.4)(40) - (0.6)(25) =1
Thus from above it can be seen that the portfolio risk has become very low in comparison of risk of
individual securities. By changing the weights it can even be reduced to zero. For example, if the
proportion of investment in A and B are 0.3846 and 0.6154 respectively, portfolio standard devi ation
becomes:
= (0.3846)(40) - (0.6154)(25) = 0
Although in above example the portfolio contains two risky assets, the portfolio has no risk at all.
Thus, the portfolio may become entirely risk-free when security returns are perfectly negatively
correlated. Therefore, diversification can substantially reduce or even eliminate risk when securities
are perfectly negatively correlated, . However, in real life it is very rare to find securities that are
perfectly negatively correlated.
4.4.3.3 Returns are uncorrelated or independent : When the returns of two securities are entirely
uncorrelated, the coefficient of correlation of these two securities would be zero and the formula for
portfolio variance will be as follows:
 p2 = x 12 12 + x 22  22 + 2x 1 x 2 r12  1 2
As r12 = 0, this may be rewritten as:
σ p2 = x12σ12 + x 22σ 22
σ p = x12 σ 12 + x 22 σ 22
coefficient is 0.
(0.4) 2 (40) 2 + (0.6) 2 (25) 2

σp =
σp = 256 + 225
σp =21.93
Thus it can be observed that the portfolio standard deviation is less than the standard deviations of
individual securities in the portfolio. Therefore, when security returns are uncorrelated, diversification
can reduce risk .
We may now tabulate the portfolio standard deviations of our illustrative portfolio having two
securities A and B, for different values of correlation coefficients between them. The proportion of
investments in A and B are 0.4 and 0.6 respectively. The individual standard deviations of A and B
are 40 and 25 respectively.
Portfolio Standard Deviations
Correlation Portfolio
coefficient Standard Deviation
1.00 31
0.60 27.73
0 21.93
-0.60 13.89
-1.00 1.00
Summarily it can be concluded that diversification reduces risk in all cases except when the security
returns are perfectly positively correlated. With the decline of correlation coefficient from +1 to -1,
the portfolio standard deviation also declines. But the risk reduction is greater when the security
returns are negatively correlated.
4.4.4 Portfolio with more than two securities

So far we have considered a portfolio with only two securities. The benefits from diversification
increase as more and more securities with less than perfectly positively correlated returns are
included in the portfolio. As the number of securities added to a portfolio increases, the standard
deviation of the portfolio becomes smaller and smaller. Hence, an investor can make th e portfolio
risk arbitrarily small by including a large number of securities with negative or zero correlation in the
portfolio.
But, in reality, securities rarely show negative or even zero correlation. Typically, securities show
some positive correlation, that is above zero but less than the perfectly positive value (+1). As a
result, diversification (that is, adding securities to a portfolio) results in some reduction in total
portfolio risk but not in complete elimination of risk. Moreover, the effects of diversification are
exhausted fairly rapidly. That is, most of the reduction in portfolio standard deviation occurs by the
time the portfolio size increases to 25 or 30 securities. Adding securities beyond this size brings
about only marginal reduction in portfolio standard deviation.
Adding securities to a portfolio reduces risk because securities are not perfectly positively correlated.
But the effects of diversification are exhausted rapidly because the securities are still positively
correlated to each other though not perfectly correlated. Had they been negatively correlated, the
portfolio risk would have continued to decline as portfolio size increased. Thus, in practice, the
benefits of diversification are limited.
4.4.5 Calculation of Return and Risk of Portfolio with more than two securities
The expected return of a portfolio is the weighted average of the returns of individual securities in
the portfolio, the weights being the proportion of investment in each security. The formula for
calculation of expected portfolio return is the same for a portfolio with two securities and for portfolios
with more than two securities. The formula is:
n
rp = ∑ x i ri
i=1
Where
rp = Expected return of portfolio.
xi = Proportion of funds invested in each security.

ri = Expected return of each security.
n = Number of securities in the portfolio.

Let us consider a portfolio with four securities having the following characteristics:
Security Returns (per cent) Proportion of investment

P 11 0.3
Q 16 0.2
R 22 0.1
S 20 0.4
The expected return of this portfolio may be calculated using the formula:
rp = (0.3)(11) + (0.2)(16) + (0.1)(22) + (0.4)(20) = 16.7 per cent
The portfolio variance and standard deviation depend on the proportion of investment in each
security as also the variance and covariance of each security included in the portfolio.
Let us take the following example to understand how we can compute the risk of multiple asset
portfolio.
Security xi σi Correlation Coefficient

X 0.25 16 X and Y = 0.7
Y 0.35 7 X and Z = 0.3
Z 0.40 9 Y and Z = 0.4
It may be noted that correlation coefficient between X and X, Y and Y, Z and Z is 1.

A convenient way to obtain the result is to set up the data required for calculation in the form of a
variance-covariance matrix.
As per data given in the example, the first cell in the first row of the matrix represents X and X the
second cell in the first row represents securities X and Y, and so on. The variance or covariance in
each cell has to be multiplied by the weights of the respective securities represented by that cell.
These weights are available in the matrix at the left side of the row and the top of the column
containing the cell.
This process may be started from the first cell in the first row and continued for all the cells till the
last cell of the last row is reached as shown below:
Weights 0.25 0.35 0.40
X Y Z
0.25 X 1 x 16 x 16 0.7 x 16 x 7 0.3 x 16 x 9
0.35 Y 0.7 x 7 x 16 1x7x7 0.4 x 7 x 9
0.40 Z 0.3 x 9 x 16 0.4 x 9 x 7 1x9x9
Once the variance-covariance matrix is set up, the computation of portfolio variance is a
comparatively simple operation. Each cell in the matrix represents a pair of two securities.
When all these products are summed up, the resulting figure is the portfolio variance. The square
root of this figure gives the portfolio standard deviation.
Thus the variance of the portfolio given in the example above can now be calculated.
σp2 = (0.25 x 0.25 x 1 x 16 x 16) + (0.25 x 0.35 x 0.7 x 16 x 7) + (0.25 x 0.40 x 0.3 x 16 x 9) +
(0.35 x 0.25 x 0.7 x 7 x 16) + (0.35 x 0.35 x 1 x 7 x 7) + (0.35 x 0.40 x 0.4 x7 x 9) + (0.40 x
0.25 x 0.3 x 9 x 16) + (0.40 x 0.35 x 0.4 x 9 x 7) + (0.40 x 0.40 x 1 x 9 x 9)
= 16+6.86+4.32+6.86+6.0025+3.528+4.32+3.528+12.96 = 64.3785
The portfolio standard deviation is:
σp= 64.3785 =8.0236
Hence, the formula for computing Portfolio Variance may also be stated as follows:
n n
 p2 =  x i x j ri j  i  j
i =1 j =1
Or
n n
p2
= ∑∑ x i x jσ i j
i=1 j=1
where
σp2 = Portfolio variance.
xi = Proportion of funds invested in security i (the first of a pair of securities).
xj = Proportion of funds invested in security j (the second of a pair of securities).
σi = Standard Deviation of security i
σj = Standard Deviation of security j
rij = The co-efficient of correlation between the pair of securities i and j
σij = The covariance between the pair of securities i and j
n = Total number of securities in the portfolio.
Thus from above discussion it can be said that a portfolio is a combina tion of assets. From a given
set of 'n' securities, any number of portfolios can be created. These portfolios may comprise of two
securities, three securities, all the way up to 'n' securities. A portfolio may contain the same securities
as another portfolio but with different weights. A new portfolios can be created either by changing
the securities in the portfolio or by changing the proportion of investment in the existing securities.
Thus summarily it can be concluded that each portfolio is characterized by its expected return and
risk. Determination of expected return and risk (variance or standard deviation) of each portfolio that
can be used to create a set of selected securities which is the first step in portfolio management and
called portfolio analysis.
5. MARKOWITZ MODEL OF RISK-RETURN OPTIMIZATION

Unlike the CAPM, the Optimal Portfolio as per Markowitz Theory is investor specific. The portfolio
selection problem can be divided into two stages:
(1) finding the mean-variance efficient portfolios and
(2) selecting one such portfolio.
Investors do not like risk and the greater the riskiness of returns on an investment, the greater will
be the returns expected by investors. There is a trade-off between risk and return which must be
reflected in the required rates of return on investment opportunities. The standard deviation (or
variance) of return measures the total risk of an investment. It is not necessary for an investor to
accept the total risk of an individual security. Investors can diversify to reduce risk. As number of
holdings approach larger, a good deal of total risk is removed by diversification.
5.1 Assumptions of the Model
It is a common phenomenon that the diversification of investments in the portfolio leads to reduction
in variance of the return, even for the same level of expected return. This model has taken into
account risks associated with investments - using variance or standard deviation of the return. This
model is based on the following assumptions. :
(i) The return on an investment adequately summarises the outcome of the investment.
(ii) The investors can visualise a probability distribution of rates of return.
(iii) The investors' risk estimates are proportional to the variance of return they perceive for a
security or portfolio.
(iv) Investors base their investment decisions on two criteria i.e. expected return and variance of
return.
(v) All investors are risk averse. For a given expected return he prefers to take minimum risk, for
a given level of risk the investor prefers to get maximum expected return.
(vi) Investors are assumed to be rational in so far as they would prefer greater returns to lesser
ones given equal or smaller risk and are risk averse. Risk aversion in this context means
merely that, as between two investments with equal expected returns, the investment with
the smaller risk would be preferred.
(vii) ‘Return’ could be any suitable measure of monetary inflows like NPV but yield has been the
most commonly used measure of return, so that where the standard deviation of returns is
referred to it is meant the standard deviation of yield about its expected value.
5.2 Efficient Frontier

Markowitz has formalised the risk return relationship and developed the concept of efficient frontier
using the Mean-Variance Dominance Principle. For selection of a portfolio, comparison between
combinations of portfolios is essential. As a rule, a portfolio is dominating another portfolio in terms
of mean and variance if there is another portfolio with:
(a) A lower expected value of return and same or higher standard deviation (risk).
(b) The same or higher standard deviation (risk) but a lower expected return.
Markowitz has defined the diversification as the process of combining assets that are less than
perfectly positively correlated in order to reduce portfolio risk without sacrificing any portfolio returns.
If an investors’ portfolio is not efficient he may:
(i) Increase the expected value of return without increasing the risk.
(ii) Decrease the risk without decreasing the expected value of return, or
(iii) Obtain some combination of increase of expected return and decrease risk.
This is possible by switching to a portfolio on the efficient frontier.
Fig. 1: Markowitz Efficient Frontier

If all the investments are plotted on the risk-return space, individual securities would be dominated
by portfolios, and the efficient frontier would be containing all Efficient Portfolios (An Efficient
Portfolio has the highest return among all portfolios with identical risk and the lowest risk among all
portfolios with identical return). Fig – 1 depicts the boundary of possible investments in securities,
A, B, C, D, E and F; and B, C, D, are lying on the efficient frontier.
The best combination of expected value of return and risk (standard deviation) depends upon the
investors’ utility function. The individual investor will want to hold that portfolio of securities which
places him on the highest indifference curve, choosing from the set of available portfolios. The dark
line at the top of the set is the line of efficient combinations, or the efficient frontier. The optimal portfolio
for an investor lies at the point where the indifference curve for the concerned investor touches the
efficient frontier. This point reflects the risk level acceptable to the investor in order to achieve a desired
return and provide maximum return for the bearable level of risk. The concept of efficient frontier and
the location of the optimal portfolio are explained with help of Fig-2.
Fig. 2 : Optimal Investment under Markowitz Model

In Fig-2 A, B, C, D, E and F define the boundary of all possible investments out of which investments
in B, C and D are the efficient portfolios lying on the efficient frontier. The attractiveness of the
investment proposals lying on the efficient frontier depends on the investors’ attitude to risk. At point
B, the level of risk and return is at optimum level. The returns are highes t at point D, but
simultaneously it carries higher risk than any other investment.
Fig.3 : Selection of Portfolios

The shaded area in Fig-3 represents all attainable or feasible portfolios, that is all the combinations
of risk and expected return which may be achieved with the available securities. The efficient frontier
contains all possible efficient portfolios and any point on the frontier dominates any point to the right
of it or below it.
Consider the portfolios represented by points B and E. B and E promise the same expected return
E (R1) but the risk associated with B is  (R1) whereas the associated with E is  (R2). Investors,
therefore, prefer portfolios on the efficient frontier rather than interior portf olios given the assumption
of risk aversion; obviously, point A on the frontier represents the portfolio with the least possible risk,
whilst D represents the portfolio with the highest possible rate of return with highest risk.
The investor has to select a portfolio from the set of efficient portfolios lying on the efficient frontier.
This will depend upon his risk-return preference. As different investors have different preferences ,
the optimal portfolio of securities will vary from one investor to another.
6. CAPITAL MARKET THEORY

The above figure 2 portrays the relationship between risk and return for efficient portfolio graphically.
Point B represents the market portfolio and if a line tangent to this point is drawn and extended upto
y-axis the point at which it will touch will be the riskless rate of interest.
Fig.4 : Selection of Portfolios

Preferred investment strategies plot along line RfBZ, representing alternative combinations of risk
and return obtainable by combining the market portfolio with borrowing or lending. This is known as
the Capital Market Line (CML). Portfolio lying on line from R f to B shall be lending portfolio as it will
involve some investment in risk-free securities and some investment in market portfolio. Portfolios
lying from B to Z will be borrowing portfolio as it will investment in market portfolio by borrowing
some amount.
The slope of the capital market line can be regarded as the reward per unit of risk borne and it is
computed as follows:
RM - R f
Slope =
M
Where RM = Market Return
Rf= Risk Free Rate of Return
σM = Standard Deviation of Market
From the Capital Market Line the expected return of a portfolio can be found as follows:
RM - R f
E(R) = Rf + × σP
M
Where σP = Standard Deviation of Portfolio
7. SINGLE INDEX MODEL (SHARPE INDEX MODEL)

This model assumes that co-movement between stocks is due to change or movement in the market
index. Casual observation of the stock prices over a period of time reveals that most of the stock
prices move with the market index. When the Sensex increases, stock prices also tend to increase
and vice-versa. This indicates that some underlying factors affect the market index as well as the
stock prices. Stock prices are related to the market index and this relationship could be used to
estimate the return on stock. Towards this purpose, the following equation can be used:
Ri = i + i Rm +i
Where,
Ri = expected return on security i
 i = intercept of the straight line or alpha co-efficient
 i = slope of straight line or beta co-efficient
R m = the rate of return on market index
i = error term.
According to the equation, the return of a stock can be divided into two components, the return due
to the market and the return independent of the market. βi indicates the sensitiveness of the stock
return to the changes in the market return. For example, βi of 1.5 means that the stock return is
expected to increase by 1.5% when the market index return increases by 1% and vice-versa.
Likewise, βi of 0.5 expresses that the individual stock return would change by 0.5 per cent when
there is a change of 1 per cent in the market return. βi of 1 indicates that the market return and the
security return are moving in tandem. The estimates of βi and αi are obtained from regression
analysis.
The single index model is based on the assumption that stocks vary together because of the common
movement in the stock market and there are no effects beyond the market (i.e. any fundamental
factor effects) that account the stocks co-movement. The expected return, standard deviation and
co-variance of the single index model represent the joint movement of securities. The mean return
is:
R i =  i +  i R m + i
The variance of security’s return:

 2 =  2 i  2 m +  2 i
The covariance of returns between securities i and j is:
 ij =  i j  2m
The variance of the security has two components namely, systematic risk or market risk and
unsystematic risk or unique risk. The variance explained by the index is referred to systematic risk.
The unexplained variance is called Residual Variance or Unsystematic Risk.
The systematic risk can be calculated by using following formula:
Systematic risk = 2 i  variance of market index
2 2
=  i m
Unsystematic risk = Total variance - Systematic risk.
i 2 =
i2 - Systematic risk.
Thus, the total risk = Systematic risk + Unsystematic risk.
= 2i  2m + 2i .
From this, the portfolio variance can be derived

 N 2
2
 N  
 p =   X i  i   m  +   Xi 2 i2
2
 
 
 i=1    i =1  

Where,
 p2
= variance of portfolio
 m 2 = expected variance of index
i 2 = variation in security’s return not related to the market index
xi = the portion of stock i in the portfolio.
β i = Beta of stock i in the portfolio

Likewise expected return on the portfolio also can be estimated. For each security α i and βi should
be estimated.
N
R P =  x i ( i +  i R m )
i =1
β i = Value of the beta for security i

xi = Proportion of the investment on security i
αi = Value of alpha for security i
N = The number of securities in the portfolio
Portfolio return is the weighted average of the estimated return for each security in the portfolio. The
weights are the respective stocks’ proportions in the portfolio.
A portfolio’s alpha value is a weighted average of the alpha values for its component securities using
the proportion of the investment in a security as weight.
N
P =  x i  i
i=1
α P = Value of the alpha for the portfolio
Similarly, a portfolio’s beta value is the weighted average of the beta values of its component stocks
using relative share of them in the portfolio as weights.
N
P = ∑ x i i
i=1
Where,
βP = Value of the beta for the portfolio.

Illustration 1
The following details are given for X and Y companies’ stocks and the Bombay Sensex for a period
of one year. Calculate the systematic and unsystematic risk for the companies’ stocks. If equal
amount of money is allocated for the stocks what would be the portfolio risk?
X Stock Y Stock Sensex

Average return 0.15 0.25 0.06
Variance of return 6.30 5.86 2.25
β 0.71 0.685
Correlation Co-efficient 0.424
Co-efficient of determination (r 2) 0.18
Solution
The co-efficient of determination (r2) i.e. square of Coefficient of Correlation gives the percentage of the
variation in the security’s return that is explained by the variation of the market index return. In the X
company stock return, 18 per cent of variation is explained by the variation of the index and 82 per cent
is not explained by the index.
According to Sharpe, the variance explained by the index is the systematic risk. The unexplained
variance or the residual variance is the unsystematic risk.
Company X:
Systematic risk = β i2  Variance of market index
= (0.71)2  2.25 = 1.134

Unsystematic risk( i )
2
= Total variance of security return - Systematic Risk
= 6.30 – 1.134
= 5.166
or
= Variance of Security Return (1-r2)
= 6.30 X (1-0.18) = 6.3 X 0.82 = 5.166
Total risk = 2 x m2 + 2

= Systematic Risk + Unsystematic Risk
= 1.134 + 5.166 = 6.30
Company Y:
Systematic risk = i2 x m2
= (0.685)2 x 2.25 = 1.056
Unsystematic risk = Total variance of the security return - systematic risk.
= 5.86-1.056 = 4.804
Portfolio Risk
 N 2
2  N 2 2 
 p =   X i  i   m  +   X i i  
2
 i=1    i=1  
= [(0.5 x 0.71 + 0.5 x 0.685) 2 2.25] + [(0.5) 2(5.166)+(0.5) 2(4.804)]

= [(0.355 + 0.3425) 2 2.25] + [(1.292 + 1.201)]
= 1.0946 + 2.493 = 3.5876
8. CAPITAL ASSET PRICING MODEL (CAPM)

The CAPM distinguishes between risk of holding a single asset and holding a portfolio of assets.
There is a trade-off between risk and return. Modern portfolio theory concentrates on risk and
stresses on risk management rather than on return management. Risk may be security risk involving
danger of loss of return from an investment in a single financial or capital asset. Security risk diffe rs
from portfolio risk, which is the probability of loss from investment in a po rtfolio of assets. Portfolio
risk is comprised of unsystematic risk and systematic risk. Unsystematic risks can be averted
through diversification and is related to random variables. Systematic risk is market related
component of portfolio risk. It is commonly measured by regression coefficient Beta or the Beta
coefficient. Low Beta reflects low risk and high Beta reflects high risk .
As the unsystematic risk can be diversified by building a portfolio, the relevant risk for determining
the prices of securities is the non-diversifiable component of the total risk. As mentioned earlier, it
can be measured by using Beta (β) a statistical parameter which measures the market sensitivity of
returns. The beta for the market is equal to 1.0. Beta explains the systema tic relationship between
the return on a security and the return on the market by using a simple linear regressio n equation.
The return on a security is taken as a dependent variable and the return on market is taken as
independent variable then R j = Rf + β (Rm – Rf). The beta parameter β in this William Sharpe model
represents the slope of the above regression relationship and measures the sensitivity or
responsiveness of the security returns to the general market returns. The portfolio beta is merely
the weighted average of the betas of individual securities included in the portfolio.
Portfolio Beta (βP) =  Proportion of Security × Beta for Security.
CAPM provides a conceptual framework for evaluating any investment decision where capital is
committed with a goal of producing future returns. CAPM is based on certain assumptions to provide
conceptual framework for evaluating risk and return. Some of the important assumptions are
discussed below:
(i) Efficient market: It is the first assumption of CAPM. Efficient market refers to the existence
of competitive market where financial securities and capital assets are bought and sold with
full information of risk and return available to all participants. In an efficient market, the price
of individual assets will reflect a real or intrinsic value of a share as the market prices will
adjust quickly to any new situation, John J. Hampton has remarked in “Financial decision
making” that although efficient capital market is not much relevant to capital budgeting
decisions, but CAPM would be useful to evaluate capital budgeting proposal because the
company can compare risk and return to be obtained by investment in machinery with risk
and return from investment in securities.
(ii) Rational investment goals: Investors desire higher return for any acceptable level of risk or
the lowest risk for any desired level of return. Such a rational choice is made on logical and
consistent ranking of proposals in order of preference for higher good to lower good and this
is the scale of the marginal efficiency of capital. Beside, transactive preferences and certainty
equivalents are other parameters of rational choice.
(iii) Risk aversion in efficient market is adhered to although at times risk seeking behaviour is
adopted for gains.
(iv) CAPM assumes that all assets are divisible and liquid assets.
(v) Investors are able to borrow freely at a risk less rate of interest i.e. borrowings can fetch equal
return by investing in safe Government securities.
(vi) Securities can be exchanged without payment of brokerage, commissions or taxes and
without any transaction cost.
(vii) Securities or capital assets face no bankruptcy or insolvency.
(viii) CAPM assumes that the Capital Market is in equilibrium.
Based on above assumptions the CAPM is developed with the main goal to formulate the return
required by investors from a single investment or a portfolio of assets. The required rate of return is
defined as the minimum expected return needed so that investors will purchase and hold an asset .
Risk and return relationship in this model stipulates higher return for higher level of risk a nd vice
versa. However, there may be exception to this general rule where markets are not efficient .
Three aspects are worth consideration:
(a) Stock market is not concerned with diversifiable risk
(b) It is not concerned with an investor having a diversified portfolio
(c) Compensation paid is restricted to non-diversifiable risk.
Thus an investor has to look into the non-diversifiable portion of risk on one side and returns on the
other side. To establish a link between the two, the required return on e expects to get for a given
level of risk has been mandated by the Capital Asset Pricing Model.
If the risk free investment R f is 5%, an investor can earn this return of 5% by investing in risk free
investment. Again if the stock market earns a rate of return Rm which is 15% then an investor
investing in stocks constituting the stock market index will earn also 15%. Thus the excess return
earned over and above the risk free return is called the market risk premium (Rm – Rf) i.e. (15% -
5%) = 10% which is the reward for undertaking risk, So, if an investment is as risky as the stock
market, the risk premium to be earned is 10%.
If an investment is 30% riskier than the stock market, it would carry risk premium i.e. 30% more than
the risk premium of the stock market i.e. 10% + 30% of 10% = 10% + 3% = 13%. β identifies how
much more risky is an investment with reference to the stock market. Hence the risk premium that a
stock should earn is β times the risk premium from the market [β × (Rm – Rf)]. The total return from
an investment is the risk free rate of return plus the risk premium. So the required return from a stock
would be Rj = Rf + [β × (Rm – Rf)]. In the above example 5% + 1.3 × (15% - 5%) = 18%
The risk premium on a stock varies in direct proportion to its Beta. If the market risk premium is 6%
and β of a stock is 1.2 then the risk premium for that stock shall be 7.2% (6% × 1.2)
Illustration 2
A company’s beta is 1.40. The market return is 14% and the risk free rate is 10%.
(i) What is the expected return of the company’s stock based on CAPM.
(ii) If the risk premium on the market goes up by 2.50% points, what would be the revised expected
return on this stock?
Solution
(i) Computation of expected return based on CAPM
Rj = Rf + β (Rm – Rf) = 10% + 1.40 (14% - 10%) = 10% + 5.6% = 15.6%
(ii) Computation of expected return if the market risk premium goes up by 2.50% points
The return from the market goes up by 2.50% i.e. 14% + 2.50% = 16.50%
Expected Return based on CAPM is given by
Rj = 10% + 1.40 (16.5% - 10%) = 10% + 1.40 × 6.5% = 10% + 9.10% = 19.10%
A graphical representation of CAPM is the Security Market Line, (SML). This line indicates the rate
of return required to compensate at a given level of risk. Plotting required return on Y axis and Beta
on the X-axis we get an upward sloping line which is given by (R m – Rf), the risk premium.
The higher the Beta value of a security, higher would be the risk premium relative to the market.
This upward sloping line is called the Security Market Line. It measures the relationship between
systematic risk and return.
Illustration 3
The risk premium for the market is 10%. Assuming Beta values of Security K are 0, 0.25, 0.42, 1.00
and 1.67. Compute the risk premium on Security K.
Solution
Market Risk Premium is 10%
 Value of K Risk Premium of K
0.00 0%
0.25 2.50%
0.42 4.20%
1.00 10.00%
1.67 16.70%
Illustration 4
Treasury Bills give a return of 5%. Market Return is 13%
(i) What is the market risk premium
(ii) Compute the  Value and required returns for the following combination of investments.
Treasury Bill 100 70 30 0
Market 0 30 70 100
Solution
Risk Premium Rm – Rf = 13% - 5% = 8%
 is the weighted average investing in portfolio consisting of market  = 1 and treasury bills ( = 0)
Treasury Bills:
Portfolio  Rj = Rf +  × (Rm – Rf)
Market
1 100:0 0 5% + 0(13%-5%)=5%
2 70:30 0.7(0)+0.3(1)=0.3 5%+0.3(13%-5%)=7.40%
3 30:70 0.3(0)+0.7(1)=0.7 5%+0.7(13%-5%)=10.60%
4 0:100 1 5%+1.0(13%-5%)=13%
8.1 Risk free Rate of Return

In CAPM, there is only one risk free rate. It presumes that the returns on a security include both
directed payments and capital appreciation. These require to be factored in judging the value of Beta
and in computing the required rate of return.
Illustration 5
Pearl Ltd. expects that considering the current market prices, the equity shareholders as per
Moderate Approach, should get a return of at least 15.50% while the current return on the market is
12%. RBI has closed the latest auction for ` 2500 crores of 182 day bills for the lowest bid of 4.3%
although there were bidders at a higher rate of 4.6% also for lots of less than ` 10 crores. What is
Pearl Ltd’s Beta?
Solution
Determining Risk free rate: Two risk free rates are given. The aggressive approach would be to
consider 4.6% while the conservative approach would be to take 4.3%. If we take the moderate value
then the simple average of the two i.e. 4.45% would be considered
Application of CAPM
Rj = Rf +  (Rm – Rf)
15.50% = 4.45% +  (12% - 4.45%)
15.50% − 4.45% 11.05
= =
12% − 4.45% 7.55
= 1.464
Illustration 6
The following information is available with respect of Jaykay Ltd.
Jay Kay Limited Market
Average DPS (` ) Average Index Dividend Yield Return on Govt.
Year
Share Price (%) Bonds
(` )
2002 242 20 1812 4 6
2003 279 25 1950 5 5
2004 305 30 2258 6 4
2005 322 35 2220 7 5
Compute Beta Value of the company as at the end of 2005. What is your observation?
Solution
Computation of Beta Value
Calculation of Returns
D1 + (P1 − P0 )
Returns =  100
P0
Year Returns
25 + ( 279 - 242 )
2002 – 2003 ×100 = 25.62%
242
30 + ( 305 - 279 )
2003 – 2004 ×100 = 20.07%
279
35 + ( 322 - 305 )
2004 – 2005 ×100 = 17.05%
305
Calculation of Returns from market Index

Year % of Index Appreciation Dividend Total
Yield % Return %
1950 − 1812
2002 − 2003  100 = 7.62% 5% 12.62%
1812
2258 − 1950
2003 − 2004  100 = 15.79% 6% 21.79%
1950
2220 − 2258
2004 − 2005  100 = ( −)1.68% 7% 5.32%
2258
Computation of Beta
Year X Y XY Y2
2002-2003 25.62 12.62 323.32 159.26
2003-2004 20.07 21.79 437.33 474.80
2004-2005 17.05 5.32 90.71 28.30
62.74 39.73 851.36 662.36
62.74 39.73
X= = 20.91, Y = = 13.24
3 3
 XY − nXY
=
2
 Y 2 − nY
851.36 - 3(20.91)(13.24)
=
662.36 - 3(13.24) 2
851.36 - 830.55 20.81
= = = 0.15
662.36 - 525.89 136.47
8.2 Under Valued and Over Valued Stocks

The CAPM model can be practically used to buy, sell or hold stocks. CAPM provides the required
rate of return on a stock after considering the risk involved in an investment. Based on current market
price or any other judgmental factors (benchmark) one can identify as to what would be the expected
return over a period of time. By comparing the required return as per CAPM with the expected return
the following investment decisions are available
(a) When required return as per CAPM < Expected Return – Buy: This is due to the stock
being undervalued i.e. the stock gives more return than what it should give.
(b) When required return as per CAPM > Expected Return – Sell: This is due to the stock
being overvalued i.e. the stock gives less return than what it should give.
(c) When required return as per CAPM = Expected Return – Hold: This is due to the stock
being correctly valued i.e. the stock gives same return than what it should give.
From another angle, if the current market price is considered as a basis of CAPM then:
(i) Actual Market Price < Market Price using CAPM, stock is undervalued
(ii) Actual market Price > Market Price using CAPM, stock is overvalued
(iii) Actual market Price = Market Price using CAPM, stock is correctly valued.
Illustration 7
Information related to an investment is as follows:
Risk free rate 10%
Market Return 15%
Beta 1.2
(i) What would be the return from this investment?
(ii) If the projected return is 18%, is the investment rightly valued?
(iii) What is your strategy?
Solution
(i) Required rate of Return as per CAPM is given by
Rj = Rf +  (Rm-Rf)
= 10 +1.2 (15-10) = 16%
(ii) Since projected return is 18%, the stock is not rightly valued rather undervalued as return as
per CAPM less than Projected Return.
(iii) Had this Project Return is considered as expected return, the decision should be to BUY the
share.
Illustration 8
The expected returns and Beta of three stocks are given below
Stock A B C
Expected Return (%) 18 11 15
Beta Factor 1.7 0.6 1.2
If the risk free rate is 9% and the expected rate of return on the market portfolio is 14% which of the
above stocks are over, under or correctly valued in the market? What shall be the strategy?
Solution
Required Rate of Return is given by
Rj = Rf +  (Rm-Rf)
For Stock A, Rj = 9 + 1.7 (14 - 9) = 17.50%
Stock B, Rj = 9 + 0.6 (14-9) = 12.00%
Stock C, Rj = 9 + 1.2 (14-9) = 15.00%
Required Return % Expected Return % Valuation Decision

17.50% 18.00% Under Valued Buy
12.00% 11.00% Over Valued Sell
15.00% 15.00% Correctly Valued Hold
8.3 Advantages and Limitations of CAPM

The advantages of CAPM can be listed as:
(i) Risk Adjusted Return: It provides a reasonable basis for estimating the required return on an
investment which has risk in built into it. Hence it can be used as Risk Adjusted Discount
Rate in Capital Budgeting.
(ii) No Dividend Company: It is useful in computing the cost of equity of a company which does
not declare dividend.
There are certain limitations of CAPM as well, which are discussed as follows:
(a) Reliability of Beta: Statistically reliable Beta might not exist for shares of many firms. It may
not be possible to determine the cost of equity of all firms using CAPM. All shortcomings that
apply to Beta value applies to CAPM too.
(b) Other Risks: By emphasing on systematic risk only, unsystematic risks are of importance to
share holders who do not possess a diversified portfolio.
(c) Information Available: It is extremely difficult to obtain important information on risk free
interest rate and expected return on market portfolio as there is multiple risk free rates for
one while for another, markets being volatile it varies over time period.
9. ARBITRAGE PRICING THEORY MODEL (APT)

Arbitrage pricing theory (APT) is used as an alternative to Capital Assets Pricing Model (CAPM).
While the CAPM formula helps to calculate the market's expected return, APT uses the risky asset's
expected return and the risk premium of a number of macroeconomic factors.
In a simplistic way, if a particular asset, say a stock, has its major influencers factors then the stocks’
return would be calculated by using the Arbitrage Pricing Theory (APT) in the following manner:
(a) Calculate the risk premium for these risk factors (beta for the risk factor 1 – interest rate, and
beta of the risk factor 2 – sector growth rate; etc. Conceptually risk premium is compensation
over and above risk free rate of return that an investor expects/ requires for bearing that risk.
(b) Adding the risk free rate of return.
Thus, the formula for APT is represented as –
E (Ri) = Rf + λ1β1 + λ 2β2 + λ 3β3 ............λ nβn
Where,
Rf = Risk Free Rate
λn = nth factor price or risk premium
βn = Sensitivity of the Factor n
The above formula provides the expected return in efficient market when equilibrium is reached.
Illustration 9
With the help of following data determine the return on the security X.
Factor Risk Premium associated with the Factor βi
Market 4% 1.3
Growth Rate of GDP 1% 0.3
Inflation -4% 0.2
Risk Free Rate of Return is 8%.

Solution
Expected Return = Rf + λ1β1 + λ 2β2 + λ 3β3
= 8% + 1.3 x 4% + 0.3 x 1% + 0.2 x (-4%)

= 8% + 5.2% + 0.3% - 0.8%
= 12.7%
As mentioned earlier while CAPM concentrate on one factor (market risk) in its Model, APT does not
specifically requires any particular type of factor to be concentrated upon. Though Stephan Ross
identified change in the following factors:
❖ Inflation
❖ Level of Industrial Production
❖ Risk Premium
❖ Term Structure of Interest Rates
Further according to Ross, if no surprise happens to these macro-economic factors then actual
returns shall be equal to expected. In case, if any unanticipated changes happens in these factors,
then formula of APT shall be as follows:
E(R) = Rf + β1 (EV1 - AV1) + β2 (EV2 – AV2) + ……… βn (EVn – AVn)
Where
(EVn – AVn) = Surprise Factor due to change in the Value of Factor
Rf = Risk Free Rate of Return
βn = Sensitivity of corresponding Macro-economic factor
10. PORTFOLIO EVALUATION METHODS

Following three ratios are used to evaluate the portfolio:
10.1 Sharpe Ratio
Sharpe Ratio measures the Risk Premium per unit of Total Risk for a security or a portfolio of
securities. The formula is as follows:
Ri - R f
S=
i
Where Ri = Return on Security/portfolio
Rf = Risk Free Rate of Return
σi = Standard Deviation of Return of Security/portfolio
S = Sharpe Ratio
Example
Let’s assume that we look at a one year period of time where an index fund earned 11%
Treasury bills earned 6%. The standard deviation of the index fund was 20%
Therefore S = (0.11 –0.06)/.20 = 25%
The Sharpe ratio is an appropriate measure of performance for an overall portfolio particularly when
it is compared to another portfolio, or another index such as the S&P 500, Small Cap index, etc.
That said however, it is not often provided in most rating services.
Example
Consider two Portfolios A and B. Let return of A be 30% and that of B be 25%. On the outset, it
appears that A has performed better than B. Let us now incorporate the risk factor and find out the
Sharpe ratios for the portfolios. Let risk of A and B be 11% and 5% respectively. This means that
the standard deviation of returns - or the volatility of returns of A is much higher than that of B.
If risk free rate is assumed to be 8%,
Sharpe ratio for portfolio A = (30% - 8%)/11% = 2 and
Sharpe ratio for portfolio B = (25% – 8%)/5% = 3.4
Higher the Sharpe Ratio, better is the portfolio on a risk adjusted return metric. Hence, our primary
judgment based solely on returns was erroneous. Portfolio B provides better risk adjusted returns
than Portfolio A and hence is the preferred investment. Producing healthy returns with low volatility
is generally preferred by most investors to high returns with high volatility. Sharpe ratio is a good
tool to use to determine a portfolio that is suitable to such investors.
10.2 Treynor Ratio

This ratio is same as Sharpe ratio with only difference that it measures the Risk Premium per unit of
Systematic Risk (β) for a security or a portfolio of securities. The formula is as follows:
Ri − R f
T=
βi
Where,
Ri = Expected return on stock i
Rf = Return on a risk less asset
σi = Standard Deviation of the rates of return for the i Security or Portfolio
i = Expected change in the rate of return on stock i associated with one unit
change in the market return (Beta)
T= Treynor Ratio
Treynor ratio is based on the premise that unsystematic or specific risk can be diversified and hence,
only incorporates the systematic risk (beta) to gauge the portfolio's performance. It measures the
returns earned in excess of those that could have been earned on a riskless investment per unit of
market risk assumed.
In above example if beta of Portfolio A and B are 1.5 and 1.1 respectively,
Treynor ratio for Portfolio A= (30%-8%)/1.5=14.67%
Treynor ratio for Portfolio B= (25%-8%)/1.1= 15.45%
The results are in line with that of the Sharpe ratio results.
Both Sharpe ratio and Treynor ratio measure risk adjusted returns. The difference lies in how risk is
defined in either case. In Sharpe ratio, risk is determined as the degree of volatility in returns - the
variability in month-on-month or period-on-period returns - which is expressed through the standard
deviation of the stream of returns numbers you are considering.
In Treynor ratio, you look at the beta of the portfolio or security - the degree of "momentum" that has
been built into the portfolio by the fund manager in order to derive his excess returns. High
momentum - or high beta (where beta is > 1) implies that the portfolio will move faster (up as well
as down) than the market.
While Sharpe ratio measures total risk (as the degree of volatility in r eturns captures all elements of
risk - systematic as well as unsystematic), the Treynor ratio captures only the systematic risk in its
computation.
When one has to evaluate the funds which are sector specific, Sharpe ratio would be more
meaningful. This is due to the fact that unsystematic risk would be present in sector specific funds.
Hence, a truer measure of evaluation would be to judge the returns based on the total risk.
On the contrary, if we consider diversified equity funds, the element of unsystem atic risk would be
very negligible as these funds are expected to be well diversified by virtue of their nature. Hence,
Treynor ratio would be more apt here.
It is widely found that both ratios usually give similar rankings. This is based on the fact that most of
the portfolios are fully diversified. To summarize, we can say that when the fund is not fully
diversified, Sharpe ratio would be a better measure of performance and when the portfolio is fully
diversified, Treynor ratio would better justify the performance of a fund.
Example: In 2019-20 where Fidelity Magellan had earned about 18%. Many bond funds had earned
13%. Which is better? In absolute numbers, 18% beats 13%. But if we then state that the bond funds
had about half the market risk, now which is better? We don’t even need to do the formula for that
analysis. But that is missing in almost all reviews by all brokers. For clarification, we do not suggest
they put all the money into either one- just that they need to be aware of the implications.
10.3 Jensen Alpha
This is the difference between a portfolio’s actual return and those that could have been made on a
benchmark portfolio with the same risk- i.e. Beta. It measures the ability of active management to
increase returns above those that are purely a reward for bearing market risk. Caveats apply
however since it will only produce meaningful results if it is used to compare two portfolios which
have similar betas.
Assume Two Portfolios
A B Market Return
Return 12 14 12
Beta 0.7 1.2 1.0
Risk Free Rate = 9%
The return expected as per CAPM
= Risk Free Return + Beta portfolio (Return of Market - Risk Free Return)
Hence, the expected return of Portfolio A using CAPM
= 0 .09 + 0.7 (0.12 - 0.09) = 0.09 + 0.021 = 0.111
Alpha = Return of Portfolio - Expected Return

= 0.12 - 0.111 = 0.009
As long as “apples are compared to apples”- in other words a computer sector fund A to computer
sector fund B - it is a viable number. But if taken out of context, it loses meaning. Alphas are found
in many rating services but are not always developed the same way- so you can’t compare an alpha
from one service to another. However, we have usually found that their relative position in the
particular rating service is to be viable. Short-term alphas are not valid. Minimum time frames are
one year- three year is more preferable.
11. SHARPE’S OPTIMAL PORTFOLIO

William Sharpe has developed a simplified variant of Markowitz model that reduces substantially its
data and computational requirements.
This model is based on desirability of an investor for excess return of risk free rate of return to beta.
Accordingly, the ranking of securities shall be based on the Sharpe Ratio and unique cut off point C*
discussed below.
The steps for finding out the stocks to be included in the optimal portfolio ar e given below:
(a) Find out the “excess return to beta” ratio for each stock under consideration.
(b) Rank them from the highest to the lowest.
(c) Proceed to calculate C i for all the stocks according to the ranked order using the following
formula:
(
N R - R f βi
σ2m  i
)
i=1 2
σei
Ci =
N β2
1 + σ2m  i
2
i = 1 σei
Where,
m2 = variance of the market index
 i2 = variance of a stock’s movement that is not associated with the movement of
market index i.e. stock’s unsystematic risk.
(d) Compute the cut-off point which the highest value of Ci and is taken as C*. The stock whose
excess-return to risk ratio is above the cut-off ratio are selected and all whose ratios are
below are rejected. The main reason for this selection is that since securities are ranked from
highest excess return to Beta to lowest, and if particular security belongs to optional portfolio
all higher ranked securities also belong to optimal portfolio.
(e) Once we came to know which securities are to be included in the optimum portfolio, we shall
calculate the percent to be invested in each security by using the following formula:
Zi
Xio =
N
 Zi
j=1
where
Bi  Ri - Ro 
Zi =  - C* 
2
σei  B i 
The first portion determines the weight each stock and total comes to 1 to ensure that all funds are
invested and second portion determines the relative investment in each security.
12. FORMULATION OF PORTFOLIO STRATEGY

Two broad choices are required for the formulation of an appropriat e Portfolio Strategy. They are
Active Portfolio Strategy and Passive Portfolio Strategy.
12.1 Active Portfolio Strategy (APS)
An APS is followed by most investment professionals and aggressive investors who strive to earn
superior return after adjustment for risk. The vast majority of funds (or schemes) available in India
follow an “active” investment approach, wherein fund managers of “active” funds spend a great deal
of time on researching individual companies, gathering extensive data about financial performance,
business strategies and management characteristics. In other words, “active” fund managers try to
identify and invest in stocks of those companies that they think will produce better returns and beat
the overall market (or Index).
There are four principles of on active strategy. These are:
(a) Market Timing : This involves departing from the normal i.e. strategy for long run asset mix to
reflect assessment of the prospect of various assets in the near future. Market timing is based on
an explicit or implicit forecast of general market movement. A variety of tools are employed for
market timing analysis namely business cycle analysis, moving average analysis, advance -decline
analysis, Econometric models. The forecast for the general market movement derived with the help
of one or more of these tools is tempted by the subjective judgment of the investors. In most cases
investor may go largely by its market sense. Those who reveal the fluctuation in the market may be
tempted to play the game of market timing but few will succeed in this game. And an investm ent
manager has to forecast the market correctly, 75% of the time just to break even after taking into
account the cost of errors and cost of transactions. According to Fisher Black, the market is just as
well as on an average when the investor is out of the market as it does when he is in. So he loses
money relative to a single buy and sale strategy by being out of the market part of the time.
(b) Sector Rotation: Sector or group rotation may apply to both stock and bond component of the
portfolio. It is used more compulsorily with respect to strategy. The components of the portfolio are
used when it involves shifting. The weighting for various industry sectors is based on their asset
outlook. If one thinks that steel and pharmaceutical would do well as compared to other sectors in
the forthcoming period he may overweigh the sector relative to their position in the market portfolio,
with the result that his portfolio will be tilted more towards these sectors in comparison to the market
portfolio.
With respect to bond portfolio sector rotation it implies a shift in the composition of the bond portfolio
in terms of quality as reflected in credit rating, coupon rate, term of maturity etc. If one anticipates a
rise in the interest rate one may shift for long term bonds to medium and short term. A long term
bond is more sensitive to interest rate variation compared to a short term bond.
(c) Security Selection: Security selection involves a search for under price security. If one has to
resort to active stock selection he may employ fundamental / technical analysis to identify stocks
which seems to promise superior return and concentrate the stock components of portfolio on them.
Such stock will be over weighted relative to their position in the market portfolio. L ike wise stock
which are perceived to be unattractive will be under weighted relative to their position in the market
portfolio.
As far as bonds are concerned security selection calls for choosing bonds which offer the highest
yields to maturity and at a given level of risk.
(d) Use of Specialised Investment Concept: To achieve superior return, one has to employ a
specialised concept/philosophy particularly with respect to investment in stocks. The concept which
have been exploited successfully are growth stock, neglected or out of favour stocks, asset stocks,
technology stocks and cyclical stocks.
The advantage of cultivating a specialized investment concept is that it helps to:
(i) Focus one’s effort on a certain kind of investment that reflects one’s a bility and talent.
(ii) Avoid the distraction of perusing other alternatives.
(iii) Master an approach or style through sustained practice and continual self criticism.
The greatest disadvantage of focusing exclusively on a specialized concept is that it may become
obsolete. The changes in the market risk may cast a shadow over the validity of the basic premise
underlying the investor philosophy.
12.2 Passive Portfolio Strategy
Active strategy was based on the premise that the capital market is characterized by efficiency which
can be exploited by resorting to market timing or sector rotation or security selection or use of special
concept or some combination of these sectors.
Passive strategy, on the other hand, rests on the tenet that the capital mark et is fairly efficient with
respect to the available information. Hence they search for superior return. Basically, passive
strategy involves adhering to two guidelines. They are:
(a) Create a well diversified portfolio at a predetermined level of risk.

(b) Hold the portfolio relatively unchanged over time unless it became adequately diversified or
inconsistent with the investor risk return preference.
A fund which is passively managed are called index funds. An Index fund is a mutual fund scheme
that invests in the securities of the target Index in the same proportion or weightage. Though it is
designed to provide returns that closely track the benchmark Index, an Index Fund carries all the
risks normally associated with the type of asset the fund holds. So, when the overall stock ma rket
rises/falls, you can expect the price of shares in the index fund to rise/fall, too. In short, an index
fund does not mitigate market risks. Indexing merely ensures that your returns will not stray far from
the returns on the Index that the fund mimics. In other words, an index fund is a fund whose daily
returns are the same as the daily returns obtained from an index. Thus, it is passively managed in
the sense that an index fund manager invests in a portfolio which is exactly the same as the portfolio
which makes up an index. For instance, the NSE-50 index (Nifty) is a market index which is made
up of 50 companies. A Nifty index fund has all its money invested in the Nifty fifty companies, held
in the same weights of the companies which are held in the index.
12.3 Selection of Securities
There are certain criteria which must be kept in mind while selecting securities. The selection criteria
for both bonds and equity shares are given as following:
12.3.1 Selection of Bonds
Bonds are fixed income avenues. The following factors have to be evaluated in selecting fixed
income avenues:
(a) Yield to maturity: The yield to maturity for a fixed income avenues represent the rate of return
earned by the investor, if he invests in the fixed income avenues and holds it till its maturity.
(b) Risk of Default: To assess such risk on a bond, one has to look at the credit rating of the
bond. If no credit rating is available relevant financial ratios of the firm have to be examined
such as debt equity, interest coverage, earning power etc and the general prospect of the
industry to which the firm belongs have to be assessed.
(c) Tax Shield: In the past, several fixed income avenues offers tax shields but at present only a
few of them do so.
(d) Liquidity: If the fixed income avenues can be converted wholly or substantially into cash at a
fairly short notice it possesses a liquidity of a high order.
12.3.2 Selection of Stock (Equity Share)
Three approaches are applied for selection of equity shares- Technical analysis, Fundamental
analysis and Random selection analysis.
(a) Technical analysis looks at price behaviours and volume data to determine whether the share
will move up or down or remain trend less.
(b) Fundamental analysis focuses on fundamental factors like earning level, growth prospects
and risk exposure to establish intrinsic value of a share. The recommendation to buy hold or
sell is based on comparison of intrinsic value and prevailing market price.
(c) Random selection analysis is based on the premise that the market is efficient and security
is properly priced.
Levels of Market Efficiency And Approach To Security Selection
Approach Technical Fundaments Random

Levels Analysis Analysis Selection
of Efficiency
1) Inefficiency Best Poor Poor
2) Weak form efficiency Poor Best Poor
3) Semi-strong efficiency Poor Good Fair
4) Strong Form efficiency Poor Fair Best
13. PORTFOLIO REVISION AND REBALANCING

It means the value of portfolio as well as its composition. The relative proportion of bond and stocks
may change as stock and bonds fluctuate in response to such changes. Portfolio rebalancing is
necessary. There are three policies of portfolio rebalancing- Buy and hold policy, Constant mix
policy, and Constant Proportion Portfolio Insurance (CPPI) policy. These policies have different pay
off under varying market conditions. Under all these policies portfolio consists of investment in stock
and bonds.
(a) Buy and Hold Policy: Sometime this policy is also called ‘do nothing policy’ as under this
strategy no balancing is required and therefore investor maintain an exposure to stocks and
therefore linearly related to the value of stock in general.
Under this strategy investors set a limit (floor) below which he does not wish the value of portfolio
should go. Therefore, he invests an amount equal to floor value in non -fluctuating assets (Bonds).
Since the value of portfolio is linearly related to value of stocks the pay -off diagram is a straight line.
This can be better understood with the help of an example. Suppose a portfolio consisting of Debt/
Bonds for ` 50,000 and ` 50,000 in equity shares currently priced at ` 100 per share. If price of the
share moves from ` 100 to ` 200 the value of portfolio shall become ` 1,50,000. The pay-off diagram
is shown in figure below i.e. a straight line:
This policy is suitable for the investor whose risk tolerance is positively related to portfolio and stock
market return but drops to zero of below floor value.
Concluding, it can be said that following are main features of this policy:
(a) The value of portfolio is positively related and linearly dependent on the value of the stock.
(b) The value of portfolio cannot fall below the floor value i.e. investment in Bonds.
(c) This policy performs better if initial percentage is higher in stock and stock outperform the
bond. Reverse will happen if stock under perform in comparison of bond or their prices goes
down.
(b) Constant Mix Policy: Contrary to above policy this policy is a ‘Do Something Policy’. Under
this policy investor maintains an exposure to stock at a constant percentage of total portfolio. This
strategy involves periodic rebalancing to required (desired) proportion by purchasing and selli ng
stocks as and when their prices goes down and up respectively. In other words this plan specifies
that value of aggressive portfolio to the value of conservative portfolio will be held constant at a pre -
determined ratio. However, it is important to this action is taken only there is change in the prices of
share at a predetermined percentage.
For example if an investor decided his portfolio shall consist of 60% in equity shares and balance
40% in bonds on upward or downward of 10% in share prices he will strike a balance.
In such situation if the price of share goes down by 10% or more, he will sell the bonds and invest
money in equities so that the proportion among the portfolio i.e. 60:40 remains the same. According
if the prices of share goes up by 10% or more he will sell equity shares and shall in bonds so that
the ratio remains the same i.e. 60:40. This strategy is suitable for the investor whose tolerance varies
proportionally with the level of wealth and such investor holds equity at all levels .
The pay-off diagram of this policy shall be as follows:
Accordingly, it gives a concave pay off, tends to do well in flat but fluctuating market.
Continuing above example let us how investor shall rebalance his portfolio (50 : 50) under different
scenarios as follows:
(a) If price decreases
Share Value Value Total Stock to Bond to
Price of of Bond Stock
Shares Bonds Switching Switching
100 Starting Level 50,000 50,000 1,00,000 - -
80 Before 40,000 50,000 90,000 - -
Rebalancing
After 45,000 45,000 90,000 - 5,000
Rebalancing
60 Before 33,750 45,000 78,750 - -
Rebalancing
After 39,360 39,390 78,750 - 5,610
Rebalancing
(b) If price increases
Share Value Value Total Stock to Bond to
Price of of Bond Stock
Shares Bonds Switching Switching
100 Starting Level 50,000 50,000 1,00,000 - -
150 Before 75,000 50,000 1,25,000 - -
Rebalancing
After Rebalancing 62,400 62,600 1,25,000 12,600 -
200 Before 83,200 62,600 1,45,800 - -
Rebalancing
After Rebalancing 72,800 73,000 1,45,800 10,400 -
(c) Constant Proportion Insurance Policy : Under this strategy investor sets a floor below which
he does not wish his asset to fall called floor, which is invested in some non -fluctuating assets such
as Treasury Bills, Bonds etc. The value of portfolio under this strategy shall not f all below this
specified floor under normal market conditions. This strategy performs well especially in bull market
as the value of shares purchased as cushion increases. In contrast in bearish market losses are
avoided by sale of shares. It should however be noted that this strategy performs very poorly in the
market hurt by sharp reversals. The following equation is used to determine equity allocation:
Target Investment in Shares = Multiplier (Portfolio Value – Floor Value)
Multiplier is a fixed constant whose value shall be more than 1.
The pay-off under this strategy can be understood better with the help of an example. Suppose
wealth of Mr. A is ` 10,00,000, a floor value of ` 7,50,000 and a multiplier of 2. Since the initial
cushion (difference between Portfolio Value and Floor) is ` 2,50,000, the initial investment in the
share shall be ` 5,00,000 (double of the initial cushion). Accordingly, initial portfolio mix shall be
consisted of ` 5,00,000 in shares and balance ` 5,00,000 in Bonds.
Situation 1: Suppose stock market rises from 100 to 150. The value of shares of Mr. A’s holding
shall rise from ` 5,00,000 to ` 7,50,000 and value of portfolio shall jump to ` 12,50,000 and value
of cushion to ` 7,50,000. Since the CPPI Policy requires the component of shares should go up to
` 10,00,000. This will necessitate the selling of bonds amounting ` 2,50,000 and re-investing
proceeds in shares.
Situation 2: If stock market falls from 100 to 80, the value of shares of portfolio falls from ` 5,00,000
to ` 4,00,000 resulting in reduction of value of portfolio to ` 9,00,000 and cushion to ` 1,50,000.
Since as per CPPI the share component should be ` 3,00,000 (` 1,50,000 x 2), hence shares of `
1,00,000 should be sold and invest in Bonds.
Thus from above it is clear that as per CPPI sell the shares as their prices fall and buy them as their
prices rise. This policy is contrary to the Constant Mix Policy and hence pay -off of CPPI shall be
convex as shown below:
(d) Comparative Evaluation
Basis Buy & Hold Constant Mix Constant Proportion

Policy Policy Portfolio Insurance
Pay-off Line Straight Concave Convex
Protection in Definite in Down Not much in Down Good in Down market
Down/Up Markets market market but and performs well in
relatively poor in Up market
Up market
Performance in flat Performs between Tend to do well in Performs poorly.
but fluctuating Constant and flat market.
market CPPI
14. ASSET ALLOCATION STRATEGIES

Many portfolios containing equities also contain other asset categories, so the management factors
are not limited to equities. There are four asset allocation strategies:
(a) Integrated Asset Allocation: Under this strategy, capital market conditions and investor
objectives and constraints are examined and the allocation that best serves the investor’s needs
while incorporating the capital market forecast is determined.
(b) Strategic Asset Allocation: Under this strategy, optimal portfolio mixes based on returns, risk
and co-variances is generated using historical information and adjusted periodically to restore target
allocation within the context of the investor’s objectives and constraints.
(c) Tactical Asset Allocation: Under this strategy, investor’s risk tolerance is assumed constant
and the asset allocation is changed based on expectations about capital market conditions.
(d) Insured Asset Allocation: Under this strategy, risk exposure for changing portfolio values
(wealth) is adjusted; more value means more ability to take risk.
15. FIXED INCOME PORTFOLIO

Fixed Income Portfolio is same as equity portfolio with difference that it consist of fixed income
securities such as bonds, debentures, money market instruments etc. Since, it mainly consists of
bonds, it is also called Bond Portfolio.
15.1 Fixed Income Portfolio Process
Just like other portfolios, following five steps are involved in fixed income portfolio.
1. Setting up objective
2. Drafting guideline for investment policy

3. Selection of Portfolio Strategy - Active and Passive
4. Selection of securities and other assets
5. Evaluation of performance with benchmark
15.2 Calculation of Return on Fixed Income Portfolio
First and foremost step in evaluation of performance of a portfolio is calculation of return. Although
there can be many types of measuring returns as per requirements but some of the commonly used
measures are :
(i) Arithmetic Average Rate of Return
(ii) Time Weighted Rate of Return
(iii) Rupee Weighted Rate of Return
(iv) Annualized Return
15.3 Fixed Income Portfolio Management Strategies
There are two strategies
(i) Passive Strategy
(ii) Active Strategy
15.3.1 Passive Strategy
As mentioned earlier Passive Strategy is based on the premise that securities are fairly priced
commensurate with the level of risk. Though investor does not try to outperform the mar ket but it
does not imply they remain totally inactive. Common strategies applied by passive investors of fixed
income portfolios are as follows:
(i) Buy and Hold Strategy: This technique is do nothing technique and investor continues with
initial selection and do not attempt to churn bond portfolio to increase return or reduce the level of
risk.
However, sometime to control the interest rate risk, the investor may set the duration of fixed income
portfolio equal to benchmarked index.
(ii) Indexation Strategy: This strategy involves replication of a predetermined benchmark well
known bond index as closely as possible.
(iii) Immunization: This strategy cannot exactly be termed as purely passive strategy but a hybrid
strategy. This strategy is more popular among pension funds. Since pension funds promised to pay
fixed amount to retires people in the form of annuities any inverse movement in interest may threaten
fund’s ability to meet their liability timely. By building an immunized portfolio the interes t rate risk
can be avoided.
(iv) Matching Cash Flows: Another stable approach to immunize the portfolio is Cash Flow
Matching. This approach involves buying of Zero Coupon Bonds to meet the promised payment out
of the proceeds realized.
15.3.2 Active Strategy
As mentioned earlier Active Strategy is usually adopted to outperform the market. Following are
some of active strategies:
(1) Forecasting Returns and Interest Rates: This strategy involves the estimation of return on basis
of change in interest rates. Since interest rate and bond values are inversely related if portfolio
manager is expecting a fall in interest rate of bonds he/she should buy with longer maturity period.
On the contrary, if he/she expected a fall in interest then he/she should sell bonds with longer period.
Based on short term yield movement following three strategies can be adopted:
(a) Bullet Strategy: This strategy involves concentration of investment in one particular bond.
This type of strategy is suitable for meeting the fund after a point of time such as meeting
education expenses of children etc. For example, if 100% of fund meant for investing in bonds
is invested in 5-years Bond.
(b) Barbell Strategy: As the name suggests this strategy involves investing equal amount in short
term and long term bonds. For example, half of fund meant for investment in bonds is invested
in 1-year Bond and balance half in 10-year Bonds.
(c) Ladder Strategy: This strategy involves investment of equal amount in bonds with different
maturity periods. For example if 20% of fund meant for investment in bonds is invested in
Bonds of periods ranging from 1 year to 5 years.
Further estimation of interest ratio is a daunting task, and quite difficult to ascertain. There are
several models available to forecast the expected interest rates which are based on:
(i) Inflation
(ii) Past Trends
(iii) Multi Factor Analysis
It should be noted that these models can be used as estimates only, as it is difficult to calculate the
accurate changes.
There is one another techniques of estimating expected change in interest rate called ‘Horizon
Analysis’. This technique requires that analyst should select a particular holding period and then
predict yield curve at the end of that period as with a given period of maturity, a bond yield curve of
a selected period can be estimated and its end price can also be calculated.
(2) Bond Swaps: This strategy involves regularly monitoring bond process to identify mispricing
and try to exploit this situation. Some of the popular swap techniques are as follows:
(a) Pure Yield Pickup Swap - This strategy involves switch from a lower yield bond to a higher
yield bonds of almost identical quantity and maturity. This strategy is suitable for portfolio
manager who is willing to assume interest rate risk as in switching from short term bond to
long term bonds to earn higher rate of interest, he may suffer a capital loss.
(b) Substitution Swap - This swapping involves swapping with similar type of bonds in terms of
coupon rate, maturity period, credit rating, liquidity and call provision but with different prices.
This type of differences exits due to temporary imbalance in the market. The ris k a portfolio
manager carries if some features of swapped bonds may not be truly identical to the swapped
one.
(c) International Spread Swap – In this swap portfolio manager is of the belief that yield spreads
between two sectors is temporarily out of line and he tries to take benefit of this mismatch.
Since the spread depends on many factor and a portfolio manager can anticipate appropriate
strategy and can profit from these expected differentials.
(d) Tax Swap – This is based on taking tax advantage by selling existing bond whose price
decreased at capital loss and set it off against capital gain in other securities and buying
another security which has features like that of disposed one.
(3) Interest Rate Swap: Interest Rate Swap is another technique that is used by Portfolio Manager.
This technique has been discussed in details in the chapter on Interest Rate Risk Management.
16. ALTERNATIVE INVESTMENT STRATEGIES IN CONTEXT

OF PORTFOLIO MANAGEMENT
Plainly speaking, Alternative Investments (AIs) are Investments other than traditional investments
(stock, bond and cash).
Features of Alternative Investments
Though here may be many features of Alternative Investment but following are some common
features.
(i) High Fees – Being a specific nature product the transaction fees are quite on higher side.
(ii) Limited Historical Rate – The data for historic return and risk is verity limited where data for
equity market for more than 100 years in available.
(iii) Illiquidity – The liquidity of Alternative Investment is not good as next buyer not be easily
available due to limited market.
(iv) Less Transparency – The level of transparency is not adequate due to limited public
information available.
(v) Extensive Research Required – Due to limited availability of market information the extensive
analysis is required by the Portfolio Managers.
(vi) Leveraged Buying – Generally investment in alternative investments is highly leveraged.
Over the time various types of AIs have been evolved but some of the important AIs are as follows:
1. Mutual Funds
2. Real Estates
3. Exchange Traded Funds
4. Private Equity
5. Hedge Funds
6. Closely Held Companies
7. Distressed Securities
8. Commodities
9. Managed Futures
10. Mezzanine Finance
Since, some of the above terms have been covered under the respective chapter in this study, we
shall cover other terms hereunder.
16.1 Real Estates
As opposed to financial claims in the form of paper or a dematerialized mode, real estate is a tangible
form of assets which can be seen or touched. Real Assets consists of land, buildings, offices,
warehouses, shops etc.
Although real investment is like any other investment but it has some special features as every
country has their own laws and paper works which makes investment in foreign properties less
attractive. However, in recent time due to globalization investment in foreign real estate has been
increased.
16.1.1 Valuation Approaches
Comparing to financial instrument the valuation of Real Estate is quite complex as number of
transactions or dealings comparing to financial instruments are very small.
Following are some characteristics that make valuation of Real Estate quite complex:
(i) Inefficient market: Information as may not be freely available as in case of financial securities.
(ii) Illiquidity: Real Estates are not as liquid as that of financial instruments.
(iii) Comparison: Real estates are only approximately comparable to other properties.
(iv) High Transaction cost: In comparison to financial instruments, the transaction and
management cost of Real Estate is quite high.
(v) No Organized market: There is no such organized exchange or market as for equity shares
and bonds.
16.1.2 Valuation of Real Estates
Generally, following four approaches are used in valuation of Real estates:
(1) Sales Comparison Approach – It is like Price Earning Multiplier as in case of equity shares.
Benchmark value of similar type of property can be used to value Real Estate.
(2) Income Approach – This approach is like value of Perpetual Debenture or Unredeemable
Preference Shares. In this approach the perpetual cash flow of potential net income (after deducting
expense) is discounted at market required rate of return.
(3) Cost Approach – In this approach, the cost is estimated to replace the building in its pres ent
form plus estimated value of land. However, adjustment of other factors such as good location,
neighbourhood is also made in it.
(4) Discounted After Tax Cash Flow Approach – In comparison to NPV technique, PV of expected
inflows at required rate of return is reduced by amount of investment.
16.2 Distressed securities
It is a kind of purchasing the securities of companies that are in or near bankruptcy. Since these
securities are available at very low price, the main purpose of buying such securities is to make
efforts to revive the sick company. Further, these securities are suitable for those investors who
cannot participate in the market and those who wants to avoid due diligence.
Now, question arises how profit can be earned from distressed securities. We can see by taking long
position in debt and short position in equity, how investor can earn arbitrage profit.
(i) In case company’s condition improves because of priority, the investor will get his interest
payment which shall be more than the dividend on his short position in equity shares.
(ii) If company is condition further deteriorates the value of both share and debenture goes down.
He will make good profit from his short position.
Risks Analysis of Investment in Distressed Securities : On the face, investment in distressed
securities appears to be a good proposition but following types of risks are need to be analyzed.
(i) Liquidity Risk – These securities may be saleable in the market.
(ii) Event Risk – Any event that particularly effect the company not economy as a whole
(iii) Market Risk – This is another type of risk though it is not important.
(iv) Human Risk – The judge’s decision on the company in distress also play a big role.
TEST YOUR KNOWLEDGE

1. Write short note on factors affecting decision of investment in fixed income securities.
2. Briefly explain the objectives of “Portfolio Management”.
3. Discuss the Capital Asset Pricing Model (CAPM) and its relevant assumptions.
Practical Questions
1. A stock costing ` 120 pays no dividends. The possible prices that the stock might sell for at
the end of the year with the respective probabilities are:
Price Probability
115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1
Required:
(i) Calculate the expected return.
(ii) Calculate the Standard deviation of returns.
2. Following information is available in respect of expected dividend, market price and market
condition after one year.
Market condition Probability Market Price Dividend per share

` `
Good 0.25 115 9
Normal 0.50 107 5
Bad 0.25 97 3
The existing market price of an equity share is ` 106 (F.V. ` 1), which is cum 10% bonus
debenture of ` 6 each, per share. M/s. X Finance Company Ltd. had offered the buy-back of
debentures at face value.
Find out the expected return and variability of returns of the equity shares if buyback offer is
accepted by the investor.
And also advise-Whether to accept buy back offer?
3. Mr. A is interested to invest ` 1,00,000 in the securities market. He selected two securities B
and D for this purpose. The risk return profile of these securities are as follows :
Security Risk (  ) Expected Return (ER)

B 10% 12%
D 18% 20%
Co-efficient of correlation between B and D is 0.15.
You are required to calculate the portfolio return of the following portfolios of B and D to be
considered by A for his investment.
(i) 100 percent investment in B only;
(ii) 50 percent of the fund in B and the rest 50 percent in D;
(iii) 75 percent of the fund in B and the rest 25 percent in D; and
(iv) 100 percent investment in D only.
Also indicate that which portfolio is best for him from risk as well as return point of view?
4. Consider the following information on two stocks, A and B :
Year Return on A (%) Return on B (%)

2006 10 12
2007 16 18

(i) The expected return on a portfolio containing A and B in the proportion of 40% and
60% respectively.
(ii) The Standard Deviation of return from each of the two stocks.
(iii) The covariance of returns from the two stocks.
(iv) Correlation coefficient between the returns of the two stocks.
(v) The risk of a portfolio containing A and B in the proportion of 40% and 60%.
5. Following is the data regarding six securities:
A B C D E F
Return (%) 8 8 12 4 9 8
Risk (Standard deviation) 4 5 12 4 5 6
(i) Assuming three will have to be selected, state which ones will be picked.
(ii) Assuming perfect correlation, show whether it is preferable to invest 75% in A and
25% in C or to invest 100% in E
6. The historical rates of return of two securities over the past ten years are given. Calculate the
Covariance and the Correlation coefficient of the two securities:
Years: 1 2 3 4 5 6 7 8 9 10
Security 1: 12 8 7 14 16 15 18 20 16 22
(Return per cent)
Security 2: 20 22 24 18 15 20 24 25 22 20
(Return per cent)
7. An investor has decided to invest to invest ` 1,00,000 in the shares of two companies,
namely, ABC and XYZ. The projections of returns from the shares of the two companies along
with their probabilities are as follows:
Probability ABC(%) XYZ(%)
.20 12 16
.25 14 10
.25 -7 28
.30 28 -2
You are required to
(i) Comment on return and risk of investment in individual shares.
(ii) Compare the risk and return of these two shares with a Portfolio of these sh ares in
equal proportions.
(iii) Find out the proportion of each of the above shares to formulate a minimum risk
portfolio.
8. The following information are available with respect of Krishna Ltd.

Year Krishna Ltd. Dividend Average Dividend Return on
Average per Share Market Index Yield Govt. bonds
share price
` `
2012 245 20 2013 4% 7%
2013 253 22 2130 5% 6%
2014 310 25 2350 6% 6%
2015 330 30 2580 7% 6%
Compute Beta Value of the Krishna Ltd. at the end of 2015 and state your observa tion.
9. The distribution of return of security ‘F’ and the market portfolio ‘P’ is given below:
Probability Return %
F P
0.30 30 -10
0.40 20 20
0.30 0 30
You are required to calculate the expected return of security ‘F’ and the market portfolio ‘P’,
the covariance between the market portfolio and security and beta for the security.
10. Given below is information of market rates of Returns and Data from two Companies A and B:
Year 2007 Year 2008 Year 2009
Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
Company B (%) 11.0 10.5 9.5
You are required to determine the beta coefficients of the Shares of Company A and Company
B.
11. The returns on stock A and market portfolio for a period of 6 years are as follows:
Year Return on A (%) Return on market portfolio
(%)
1 12 8
2 15 12
3 11 11
4 2 -4
5 10 9.5
6 -12 -2

(i) Characteristic line for stock A
(ii) The systematic and unsystematic risk of stock A.
12. The rates of return on the security of Company X and market portfolio for 10 periods
are given below:
Period Return of Security X (%) Return on Market Portfolio (%)
1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 −5 8
7 17 −6
8 19 5
9 −7 6
10 20 11
(i) What is the beta of Security X?
(ii) What is the characteristic line for Security X?
13. Expected returns on two stocks for particular market returns are given in the following table:
Market Return Aggressive Defensive

7% 4% 9%
25% 40% 18%
You are required to calculate:
(a) The Betas of the two stocks.
(b) Expected return of each stock, if the market return is equally likely to be 7% or 25%.
(c) The Security Market Line (SML), if the risk free rate is 7.5% and market return is
equally likely to be 7% or 25%.
(d) The Alphas of the two stocks.
14. A study by a Mutual fund has revealed the following data in respect of three securities:
Security σ (%) Correlation with Index, Pm
A 20 0.60
B 18 0.95
C 12 0.75
The standard deviation of market portfolio (BSE Sensex) is observed to be 15%.
(i) What is the sensitivity of returns of each stock with respect to the market?
(ii) What are the covariances among the various stocks?
(iii) What would be the risk of portfolio consisting of all the three stocks equally?
(iv) What is the beta of the portfolio consisting of equal investment in each stock?
(v) What is the total, systematic and unsystematic risk of the portfolio in (iv)?
15. Mr. X owns a portfolio with the following characteristics:
Security A Security B Risk Free security
Factor 1 sensitivity 0.80 1.50 0
Factor 2 sensitivity 0.60 1.20 0
Expected Return 15% 20% 10%
It is assumed that security returns are generated by a two factor model.

(i) If Mr. X has ` 1,00,000 to invest and sells short ` 50,000 of security B and purchases
` 1,50,000 of security A what is the sensitivity of Mr. X’s portfolio to the two factors?
(ii) If Mr. X borrows ` 1,00,000 at the risk free rate and invests the amount he borrows
along with the original amount of ` 1,00,000 in security A and B in the same proportion
as described in part (i), what is the sensitivity of the portfolio to the two factors?
(iii) What is the expected return premium of factor 2?
16. Mr. Tempest has the following portfolio of four shares:
Name Beta Investment ` Lac.
Oxy Rin Ltd. 0.45 0.80
Boxed Ltd. 0.35 1.50
Square Ltd. 1.15 2.25
Ellipse Ltd. 1.85 4.50
The risk-free rate of return is 7% and the market rate of return is 14%.
Required.
(i) Determine the portfolio return. (ii) Calculate the portfolio Beta.
17. Mr. Abhishek is interested in investing ` 2,00,000 for which he is considering following three
alternatives:
(i) Invest ` 2,00,000 in Mutual Fund X (MFX)
(ii) Invest ` 2,00,000 in Mutual Fund Y (MFY)
(iii) Invest ` 1,20,000 in Mutual Fund X (MFX) and ` 80,000 in Mutual Fund Y (MFY)
Average annual return earned by MFX and MFY is 15% and 14% respectively. Risk free ra te
of return is 10% and market rate of return is 12%.
Covariance of returns of MFX, MFY and market portfolio Mix are as follow:
MFX MFY Mix
MFX 4.800 4.300 3.370
MFY 4.300 4.250 2.800
Mix 3.370 2.800 3.100
(i) variance of return from MFX, MFY and market return,
(ii) portfolio return, beta, portfolio variance and portfolio standard deviation,
(iii) expected return, systematic risk and unsystematic risk; and
(iv) Sharpe ratio, Treynor ratio and Alpha of MFX, MFY and Portfolio Mix
18. Amal Ltd. has been maintaining a growth rate of 12% in dividends. The company has paid
dividend @ ` 3 per share. The rate of return on market portfolio is 15% and the risk -free rate
of return in the market has been observed as10%. The beta co-efficient of the company’s
share is 1.2.
You are required to calculate the expected rate of return on the company’s shares as per
CAPM model and the equilibrium price per share by dividend growth model.
19. The following information is available in respect of Security X
Equilibrium Return 15%
Market Return 15%
7% Treasury Bond Trading at $140
Covariance of Market Return and Security Return 225%
Coefficient of Correlation 0.75
You are required to determine the Standard Deviation of Market Return and Security Return.
20. Assuming that shares of ABC Ltd. and XYZ Ltd. are correctly priced according to Capital
Asset Pricing Model. The expected return from and Beta of these shares are as follows:
Share Beta Expected return
ABC 1.2 19.8%
XYZ 0.9 17.1%
You are required to derive Security Market Line.
21. A Ltd. has an expected return of 22% and Standard deviation of 40%. B Ltd. has an expected
return of 24% and Standard deviation of 38%. A Ltd. has a beta of 0.86 and B Ltd. a beta of
1.24. The correlation coefficient between the return of A Ltd. and B Ltd. is 0.72. The Standard
deviation of the market return is 20%. Suggest:
(i) Is investing in B Ltd. better than investing in A Ltd.?
(ii) If you invest 30% in B Ltd. and 70% in A Ltd., what is your expected rate of return and
portfolio Standard deviation?
(iii) What is the market portfolios expected rate of return and how much is the risk -free
rate?
(iv) What is the beta of Portfolio if A Ltd.’s weight is 70% and B Ltd.’s weight is 30%?
22. XYZ Ltd. has substantial cash flow and until the surplus funds are utilised to meet the future
capital expenditure, likely to happen after several months, are invested in a portfolio of short -
term equity investments, details for which are given below:
Investment No. of Beta Market price per share Expected dividend

shares ` yield
I 60,000 1.16 4.29 19.50%
II 80,000 2.28 2.92 24.00%
III 1,00,000 0.90 2.17 17.50%
IV 1,25,000 1.50 3.14 26.00%
The current market return is 19% and the risk free rate is 11%.
Required to:
(i) Calculate the risk of XYZ’s short-term investment portfolio relative to that of the market;
(ii) Whether XYZ should change the composition of its portfolio.
23. A company has a choice of investments between several different equity oriented mutual
funds. The company has an amount of `1 crore to invest. The details of the mutual funds are
as follows:
Mutual Fund Beta

A 1.6
B 1.0
C 0.9
D 2.0
E 0.6
Required:
(i) If the company invests 20% of its investment in each of the first two mutual funds and
an equal amount in the mutual funds C, D and E, what is the beta of the portfolio?
(ii) If the company invests 15% of its investment in C, 15% in A, 10% in E and the balance
in equal amount in the other two mutual funds, what is the beta of the portfolio?
(iii) If the expected return of market portfolio is 12% at a beta factor of 1.0, what will be
the portfolios expected return in both the situations given above?
24. Suppose that economy A is growing rapidly and you are managing a global equity fund and
so far you have invested only in developed-country stocks only. Now you have decided to
add stocks of economy A to your portfolio. The table below shows the expected rates of
return, standard deviations, and correlation coefficients (all estimates are for aggregate stock
market of developed countries and stock market of Economy A).
Developed Stocks of
Country Stocks Economy A
Expected rate of return (annualized percentage) 10 15
Risk [Annualized Standard Deviation (%)] 16 30
Correlation Coefficient () 0.30

Assuming the risk-free interest rate to be 3%, you are required to determine:
(a) What percentage of your portfolio should you allocate to stocks of Economy A if you
want to increase the expected rate of return on your portfolio by 0.5%?
(b) What will be the standard deviation of your portfolio assuming that stocks of Economy
A are included in the portfolio as calculated above?
(c) Also show how well the Fund will be compensated for the risk undertaken due to
inclusion of stocks of Economy A in the portfolio?
25. Mr. FedUp wants to invest an amount of ` 520 lakhs and had approached his Portfolio
Manager. The Portfolio Manager had advised Mr. FedUp to invest in the following manner:
Security Moderate Better Good Very Good Best

Amount (in ` Lakhs) 60 80 100 120 160
Beta 0.5 1.00 0.80 1.20 1.50
You are required to advise Mr. FedUp in regard to the following, using Capital Asset Pricing
Methodology:
(i) Expected return on the portfolio, if the Government Securities are at 8% and the NIFTY
is yielding 10%.
(ii) Advisability of replacing Security 'Better' with NIFTY.
26. Your client is holding the following securities:
Particulars of Securities Cost Dividends/Interest Market price Beta
` ` `
Equity Shares:
Gold Ltd. 10,000 1,725 9,800 0.6
Silver Ltd. 15,000 1,000 16,200 0.8
Bronze Ltd. 14,000 700 20,000 0.6
GOI Bonds 36,000 3,600 34,500 0.01
Average return of the portfolio is 15.7%, calculate:

(i) Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).
(ii) Risk free rate of return.
27. A holds the following portfolio:
Share/Bond Beta Initial Price Dividends Market Price at end of year

` ` `
Epsilon Ltd. 0.8 25 2 50
Sigma Ltd. 0.7 35 2 60
Omega Ltd. 0.5 45 2 135
GOI Bonds 0.01 1,000 140 1,005
Calculate:
(i) The expected rate of return of each security using Capital Asset Pricing Method
(CAPM)
(ii) The average return of his portfolio.
Risk-free return is 14%.
28. Your client is holding the following securities:
Particulars of Cost Dividends Market Price BETA

Securities ` ` `
Equity Shares:
Co. X 8,000 800 8,200 0.8
Co. Y 10,000 800 10,500 0.7
Co. Z 16,000 800 22,000 0.5
PSU Bonds 34,000 3,400 32,300 0.2
Assuming a Risk-free rate of 15%, calculate:

– Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).
– Simple Average return of the portfolio.
29. An investor is holding 1,000 shares of Fatlass Company. Presently the rate of dividend being
paid by the company is ` 2 per share and the share is being sold at ` 25 per share in the
market. However, several factors are likely to change during the course of the year as
indicated below:
Existing Revised
Risk free rate 12% 10%
Market risk premium 6% 4%
Beta value 1.4 1.25
Expected growth rate 5% 9%
In view of the above factors whether the investor should buy, hold or sell the shares? And
why?
30. An investor is holding 5,000 shares of X Ltd. Current year dividend rate is ` 3/ share. Market
price of the share is ` 40 each. The investor is concerned about several factors which are
likely to change during the next financial year as indicated below:
Current Year Next Year

Dividend paid /anticipated per share (`) 3 2.5
Market Risk Premium 5% 4%
Beta Value 1.3 1.4
Expected growth 9% 7%
In view of the above, advise whether the investor should buy, hold or sell the shares.
31. An investor has two portfolios known to be on minimum variance set for a population of three
securities A, B and C having below mentioned weights:
WA WB WC
Portfolio X 0.30 0.40 0.30
Portfolio Y 0.20 0.50 0.30
It is supposed that there are no restrictions on short sales.

(i) What would be the weight for each stock for a portfolio constructed by investing `
5,000 in portfolio X and ` 3,000 in portfolio Y?.
(ii) Suppose the investor invests ` 4,000 out of ` 8,000 in security A. How he will allocate
the balance between security B and C to ensure that his portfolio is on minimum
variance set?
32. X Co., Ltd., invested on 1.4.2009 in certain equity shares as below:
Name of Co. No. of shares Cost (`)
M Ltd. 1,000 (` 100 each) 2,00,000
N Ltd. 500 (` 10 each) 1,50,000
In September, 2009, 10% dividend was paid out by M Ltd. and in October, 2009, 30% dividend
paid out by N Ltd. On 31.3.2010 market quotations showed a value of ` 220 and ` 290 per
share for M Ltd. and N Ltd. respectively.
On 1.4.2010, investment advisors indicate (a) that the dividends from M Ltd. and N Ltd. for
the year ending 31.3.2011 are likely to be 20% and 35%, respectively and (b) that the
probabilities of market quotations on 31.3.2011 are as below:
Probability factor Price/share of M Ltd. Price/share of N Ltd.
0.2 220 290
0.5 250 310
0.3 280 330

(i) Calculate the average return from the portfolio for the year ended 31.3.2010;
(ii) Calculate the expected average return from the portfolio for the year 2010 -11; and
(iii) Advise X Co. Ltd., of the comparative risk in the two investments by calculating the
standard deviation in each case.
33. An investor holds two stocks A and B. An analyst prepared ex-ante probability distribution for
the possible economic scenarios and the conditional returns for two stocks and the market
index as shown below:
Economic scenario Probability Conditional Returns %
A B Market
Growth 0.40 25 20 18
Stagnation 0.30 10 15 13
Recession 0.30 -5 -8 -3
The risk free rate during the next year is expected to be around 11%. Determine whether the
investor should liquidate his holdings in stocks A and B or on the contrary make fresh
investments in them. CAPM assumptions are holding true.
34. Following are the details of a portfolio consisting of three shares:
Share Portfolio weight Beta Expected return in % Total variance

A 0.20 0.40 14 0.015
B 0.50 0.50 15 0.025
C 0.30 1.10 21 0.100
Standard Deviation of Market Portfolio Returns = 10%

You are given the following additional data:
Covariance (A, B) = 0.030
Covariance (A, C) = 0.020
Covariance (B, C) = 0.040
Calculate the following:
(i) The Portfolio Beta
(ii) Residual variance of each of the three shares
(iii) Portfolio variance using Sharpe Index Model

(iv) Portfolio variance (on the basis of modern portfolio theory given by Markowitz)
35. Ramesh wants to invest in stock market. He has got the following information about individual
securities:
Security Expected Return Beta σ2 ci

A 15 1.5 40
B 12 2 20
C 10 2.5 30
D 09 1 10
E 08 1.2 20
F 14 1.5 30
Market index variance is 10 percent and the risk free rate of return is 7%. What should be the
optimum portfolio assuming no short sales?
36. A Portfolio Manager (PM) has the following four stocks in his portfolio:
Security No. of Shares Market Price per share β

(`)
VSL 10,000 50 0.9
CSL 5,000 20 1.0
SML 8,000 25 1.5
APL 2,000 200 1.2
Compute the following:

(i) Portfolio beta.
(ii) If the PM seeks to reduce the beta to 0.8, how much risk free investment should he bring
in?
(iii) If the PM seeks to increase the beta to 1.2, how much risk free investment should he
bring in?
37. A has portfolio having following features:
Security β Random Error σei Weight

L 1.60 7 0.25
M 1.15 11 0.30
N 1.40 3 0.25
K 1.00 9 0.20
You are required to find out the risk of the portfolio if the standard deviation of the market
index (m) is 18%.
38. Mr. Tamarind intends to invest in equity shares of a company the value of which
depends upon various parameters as mentioned below:
Factor Beta Expected value in % Actual value in %

GNP 1.20 7.70 7.70
Inflation 1.75 5.50 7.00
Interest rate 1.30 7.75 9.00
Stock market index 1.70 10.00 12.00
Industrial production 1.00 7.00 7.50
If the risk free rate of interest be 9.25%, how much is the return of the share under Arbitrage
Pricing Theory?
39. The total market value of the equity share of O.R.E. Company is ` 60,00,000 and the total
value of the debt is ` 40,00,000. The treasurer estimate that the beta of the stock is currently
1.5 and that the expected risk premium on the market is 10 per cent. The treasury bill rate is
8 per cent.
Required:
(i) What is the beta of the Company’s existing portfolio of assets?
(ii) Estimate the Company’s Cost of capital and the discount rate for an expansion of the
company’s present business.
40. Mr. Nirmal Kumar has categorized all the available stock in the market into the following
types:
(i) Small cap growth stocks
(ii) Small cap value stocks
(iii) Large cap growth stocks
(iv) Large cap value stocks
Mr. Nirmal Kumar also estimated the weights of the above categories of stocks in the market
index. Further, the sensitivity of returns on these categories of stocks to the three important
factor are estimated to be:
Category of Weight in the Factor I (Beta) Factor II Factor III

Stocks Market Index (Book Price) (Inflation)
Small cap growth 25% 0.80 1.39 1.35
Small cap value 10% 0.90 0.75 1.25
Large cap growth 50% 1.165 2.75 8.65
Large cap value 15% 0.85 2.05 6.75
Risk Premium 6.85% -3.5% 0.65%
The rate of return on treasury bonds is 4.5%

Required:
(a) Using Arbitrage Pricing Theory, determine the expected return on the market index.
(b) Using Capital Asset Pricing Model (CAPM), determine the expected return on the
market index.
(c) Mr. Nirmal Kumar wants to construct a portfolio constituting only the ‘small cap value’
and ‘large cap growth’ stocks. If the target beta for the desired portfolio is 1, determine
the composition of his portfolio.
41. The following are the data on five mutual funds:
Fund Return Standard Deviation Beta
A 15 7 1.25
B 18 10 0.75
C 14 5 1.40
D 12 6 0.98
E 16 9 1.50
You are required to compute Reward to Volatility Ratio and rank these portfolio using:
 Sharpe method and
 Treynor's method
assuming the risk free rate is 6%.
ANSWERS/ SOLUTIONS
1. (i) Here, the probable returns have to be calculated using the formula
D P1 − P0
R= +
P0 P0
Calculation of Probable Returns
Possible prices (P 1) P1-P0 [(P1-P0)/ P0 ] x 100

` ` Return (per cent)
115 -5 -4.17
120 0 0.00
125 5 4.17
130 10 8.33
135 15 12.50
140 20 16.67
Alternatively, it can be calculated as follows:

Calculation of Expected Returns
Possible return Probability Product
Xi p(Xi) X1-p(Xi)
-4.17 0.1 -0.417
0.00 0.1 0.000
4.17 0.2 0.834
8.33 0.3 2.499
12.50 0.2 2.500
16.67 0.1 1.667
X = 7.083
Expected return X = 7.083 per

Alternatively, it can also be calculated as follows:
Expected Price = 115 x 0.1 + 120 x 0.1 + 125 x 0.2 + 130 x 0.3 + 135 x 0 .2 + 140 x
0.1 = 128.50
128.50 − 120
Return =  100 = 7.0833%
120
(ii) Calculation of Standard Deviation of Returns
Probable Probability Deviation Deviation Product

squared
return Xi p(Xi) (Xi – X) (Xi – X)² (Xi – X)²p(Xi)
-4.17 0.1 -11.253 126.63 12.66
0.00 0.1 -7.083 50.17 5.017
4.17 0.2 -2.913 8.49 1.698
8.33 0.3 1.247 1.56 0.467
12.50 0.2 5.417 29.34 5.869
16.67 0.1 9.587 91.91 9.191
σ² = 34.902
Variance, σ² = 34.902 per cent

Standard deviation, σ= 34.902 = 5.908 per cent
2. The Expected Return of the equity share may be found as follows:
Market Condition Probability Total Return Cost (*) Net Return

Good 0.25 ` 124 ` 100 ` 24
Normal 0.50 ` 112 ` 100 ` 12
Bad 0.25 ` 100 ` 100 `0
 12 
Expected Return = (24  0.25) + (12  0.50) + (0  0.25) = 12=    100 = 12%
 100 
The variability of return can be calculated in terms of standard deviation.
V SD = 0.25 (24 – 12)2 + 0.50 (12 – 12)2 + 0.25 (0 – 12)2
= 0.25 (12) 2 + 0.50 (0) 2 + 0.25 (–12)2
= 36 + 0 + 36
SD = 72
SD = 8.485 or say 8.49
(*) The present market price of the share is ` 106 cum bonus 10% debenture of ` 6 each;
hence the net cost is ` 100.
M/s X Finance company has offered the buyback of debenture at face value. There is
reasonable 10% rate of interest compared to expected return 12% from the market.
Considering the dividend rate and market price the creditworthiness of the company se ems
to be very good. The decision regarding buy-back should be taken considering the maturity
period and opportunity in the market. Normally, if the maturity period is low say up to 1 year
better to wait otherwise to opt buy back option.
3. We have Ep = W1E1 + W3E3 + ………… WnEn
n n
and for standard deviation σ 2p = ∑∑ w i w jσ ij
i=1 j=1
n n
σ2p = ∑∑ w i w jρij σ i σ j
i=1 j=1
Two asset portfolio

σ2p = w21σ21 + w22σ22 + 2 w1w2σ1σ2ρ12
Substituting the respective values we get,
(i) All funds invested in B
Ep = 12%
σp = 10%
(ii) 50% of funds in each of B & D
Ep = 0.50X12%+0.50X20%=16%
σ2p = (0.50) 2(10%)2 + (0.50)2(18%)2 +2(0.50)(0.50)(0.15)(10%)(18%)
σ2p = 25 + 81 + 13.5 = 119.50
σp = 10.93%
(iii) 75% in B and 25% in D

Ep = 0.75%X12%+0.25%X20=14%
σ2p = (0.75) 2(10%)2 + (0.25)2(18%)2 +2(0.75)(0.25)(0.15)(10%)(18%)
σ2p = 56.25 + 20.25 + 10.125 = 86.625
σp = 9.31%
(iv) All funds in D
Ep = 20%
σp = 18.0%
Portfolio (i) (ii) (iii) (iv)

Return 12 16 14 20
σ 10 10.93 9.31 18
In the terms of return, we see that portfolio (iv) is the best portfolio. In terms of risk we
see that portfolio (iii) is the best portfolio.
4. (i) Expected return of the portfolio A and B
E (A) = (10 + 16) / 2 = 13%
E (B) = (12 + 18) / 2 = 15%
N
Rp =  X iR i = 0.4(13) + 0.6(15) = 14.2%
i −l
(ii) Stock A:
Variance = 0.5 (10 – 13)² + 0.5 (16 – 13) ² = 9
Standard deviation = 9 = 3%
Stock B:
Variance = 0.5 (12 – 15) ² + 0.5 (18 – 15) ² = 9
Standard deviation = 3%
(iii) Covariance of stocks A and B
CovAB = 0.5 (10 – 13) (12 – 15) + 0.5 (16 – 13) (18 – 15) = 9
(iv) Correlation of coefficient
Cov AB 9
rAB = = =1
 A B 3  3
(v) Portfolio Risk
P = X 2 A 2 A + X 2B2B + 2X A X B ( A B AB )
= (0.4 )2 (3)2 + (0.6)2 (3)2 + 2(0.4 )(0.6)(3)(3)(1)

= 1.44 + 3.24 + 4.32 = 3%
5. (i) Security A has a return of 8% for a risk of 4, whereas B and F have a higher risk for
the same return. Hence, among them A dominates.
For the same degree of risk 4, security D has only a return of 4%. Hence, D is also
dominated by A.
Securities C and E remain in reckoning as they have a higher return though with higher
degree of risk.
Hence, the ones to be selected are A, C & E.
(ii) The average values for A and C for a proportion of 3 : 1 will be :
(3  4) + (1 12)
Risk = = 6%
4
(3  8) + (1 12)
Return = = 9%
4
Therefore: 75% A E
25% C _
Risk 6 5
Return 9% 9%
For the same 9% return the risk is lower in E. Hence, E will be preferable.
6. Calculation of Covariance
Year R1 Deviation Deviation R2 Deviation Deviation Product of

deviations
(R 1 - R 1 ) (R1 - R1) 2 (R 2 - R 2 ) (R 2 - R 2 ) 2
1 12 -2.8 7.84 20 -1 1 2.8

2 8 -6.8 46.24 22 1 1 -6.8
3 7 -7.8 60.84 24 3 9 -23.4
4 14 -0.8 0.64 18 -3 9 2.4
5 16 1.2 1.44 15 -6 36 -7.2

6 15 0.2 0.04 20 -1 1 -0.2
7 18 3.2 10.24 24 3 9 9.6
8 20 5.2 27.04 25 4 16 20.8
9 16 1.2 1.44 22 1 1 1.2
10 22 7.2 51.84 20 -1 1 -7.2
148 Σ=207.60 210 Σ=84.00
R1 = = 14.8 R2 = = 21
10 10
i =1
[R 1 − R 1 ] [R 2 − R 2 ]
Covariance = = -8/10 = -0.8
N
Standard Deviation of Security 1
(R1 - R1) 2
σ1 =
N
207.60
σ1 = = 20.76
10
σ1 = 4.56
Standard Deviation of Security 2
(R 2 - R 2 ) 2
σ2 =
N
84
σ2 = = 8.40
10
σ 2 = 2.90
Alternatively, Standard Deviation of securities can also be calculated as follows:
Calculation of Standard Deviation

Year R1 R 12 R2 R 22
1 12 144 20 400
2 8 64 22 484
3 7 49 24 576
4 14 196 18 324
5 16 256 15 225
6 15 225 20 400
7 18 324 24 576
8 20 400 25 625
9 16 256 22 484
10 22 484 20 400
148 2398 210 4494
Standard deviation of security 1:
σ1 =
N∑R12 - (∑R1)2
N2
(10 × 2398) - (148) 2 23980 - 21904

=
10 ×10 100
=
20.76
= = 4.56
Standard deviation of security 2:
2 =
N  R − ( R
2
2 2)
2
N2
(10  4494) − (210) 2
=
10  10 44940− 44100
=
100
840
= = 8.4 = 2.90
100
Correlation Coefficient
Cov − 0.8 − 0.8
r12 = =
1  2 4.56  2.90 13.22
= = -0.0605
7. (i)
Probability ABC (%) XYZ (%) 1X2 (%) 1X3 (%)

(1) (2) (3) (4) (5)
0.20 12 16 2.40 3.2
0.25 14 10 3.50 2.5
0.25 -7 28 -1.75 7.0
0.30 28 -2 8.40 -0.6
Average return 12.55 12.1
Hence the expected return from ABC = 12.55% and XYZ is 12.1%
Probability (ABC- ABC ) (ABC- ABC )2 1X3 (XYZ- XYZ ) (XYZ- XYZ )2 (1)X(6)
(1) (2) (3) (4) (5) (6)
0.20 -0.55 0.3025 0.06 3.9 15.21 3.04
0.25 1.45 2.1025 0.53 -2.1 4.41 1.10
0.25 -19.55 382.2025 95.55 15.9 252.81 63.20
0.30 15.45 238.7025 71.61 -14.1 198.81 59.64
167.75 126.98
 2 ABC = 167.75(%)2 ;  ABC = 12.95%
 2 XYZ = 126.98(%)2 ;  XYZ = 11.27%
(ii) In order to find risk of portfolio of two shares, the covariance between the two is
necessary here.
Probability (ABC- ABC ) (XYZ- XYZ ) 2X3 1X4
(1) (2) (3) (4) (5)
0.20 -0.55 3.9 -2.145 -0.429
0.25 1.45 -2.1 -3.045 -0.761
0.25 -19.55 15.9 -310.845 -77.71
0.30 15.45 -14.1 -217.845 -65.35
-144.25
 2P = (0.52 x 167.75) + (0.5 2 x 126.98) + 2 x (-144.25) x 0.5 x 0.5
 2P = 41.9375 + 31.745 – 72.125
 2P = 1.5575 or 1.56(%)
 P = 1.56 = 1.25%
E (Rp) = (0.5 x 12.55) + (0.5 x 12.1) = 12.325%
Hence, the return is 12.325% with the risk of 1.25% for the portfolio. Thus the portfolio
results in the reduction of risk by the combination of two shares.
(iii) For constructing the minimum risk portfolio the condition to be satisfied is
σ X2 - rAXσ A σ X σ 2X - Cov.AX
XABC = or =
σ 2A + σ X2 - 2rAXσ A σ X σ 2A + σ 2X - 2 Cov.AX
σX = Std. Deviation of XYZ

σA = Std. Deviation of ABC
rAX= Coefficient of Correlation between XYZ and ABC
Cov.AX = Covariance between XYZ and ABC.
Therefore,
126.98 - (-144.25) 271.23
% ABC = = = 0.46 or 46%
126.98 + 167.75 - [2 × (-144.25)] 583.23
% ABC = 46%, XYZ = 54%

(1 – 0.46) =0.54
8. (i) Computation of Beta Value
Calculation of Returns
D1 + (P1 − P0 )
Returns =  100
P0
Year Returns
22 + (253 − 245)
2012 – 13  100 = 12.24%
245
25 + (310 − 253)
2013 – 14  100 = 32.41%
253
30 + (330 − 310)
2014 – 15  100 = 16.13%
310
Calculation of Returns from market Index

Year % of Index Appreciation Dividend Total Return
Yield % %
(2130 − 2013)
2012–13  100 = 5.81% 5% 10.81%
2013
(2350 − 2130)
2013–14  100 = 10.33% 6% 16.33%
2130
(2580 − 2350)
2014–15  100 = 9.79% 7% 16.79%
2350
Computation of Beta
Year Krishna Ltd. (X) Market Index (Y) XY Y2
2012–13 12.24% 10.81% 132.31 116.86
2013–14 32.41% 16.33% 529.25 266.67
2014–15 16.13% 16.79% 270.82 281.90
Total 60.78% 43.93% 932.38 665.43
60.78
Average Return of Krishna Ltd. = = 20.26%
3
43.93
Average Market Return = = 14.64%
3
Beta (β) =
 XY - nX Y = 932.38 - 3 × 20.26 × 14.64
= 1.897
 Y − n(Y ) 665.43 - 3(14.64)2
2 2
(ii) Observation
Expected Return (%) Actual Action

Return
(%)
2012 – 13 6%+ 1.897(10.81% - 6%) = 15.12% 12.24% Sell
2013 – 14 6%+ 1.897(16.33% - 6%) = 25.60% 32.41% Buy
2014 – 15 6%+ 1.897(16.79% - 6%) = 26.47% 16.13% Sell
9. Security F
Prob(P) Rf PxRf Deviations of F (Deviation) 2 of (Deviations) 2 PX
(Rf – ERf) F
0.3 30 9 13 169 50.7
0.4 20 8 3 9 3.6
0.3 0 0 -17 289 86.7
ER f =17 Var f =141
STDEV  f = 141 = 11.87

Market Portfolio, P
RM PM Exp. Dev. of P (Dev. of P) 2 (DeV.) 2 (Deviation of F) Dev. of F x
% Return (RM -ERM ) PM x (Deviation of Dev. of P) x P
RM x PM P)
-10 0.3 -3 -24 576 172.8 -312 -93.6
20 0.4 8 6 36 14.4 18 7.2
30 0.3 9 16 256 76.8 -272 -81.6
ERM =14 Var M =264 =Co Var P M
 M =16.25 =- 168
Co Var PM − 168
Beta= = = − .636
 M2 264
10. Company A:
Year Return % Market return % Deviation Deviation D Ra  Rm 2

(Ra) (Rm) R(a) Rm DRm
1 13.0 12.0 1.57 1.33 2.09 1.77
2 11.5 11.0 0.07 0.33 0.02 0.11
3 9.8 9.0 −1.63 −1.67 2.72 2.79
34.3 32.0 4.83 4.67
Average Ra = 11.43
Average Rm = 10.67
Covariance =
∑(Rm - Rm )(Ra - Ra )
N
4.83
Covariance = = 1.61
3
Variance (σm 2) =
∑ (Rm - R m ) 2
N
4.67
= = 1.557
3
1.61
β= = 1.03
1.557
Company B:
Year Return % (Rb) Market return Deviation Deviation D Rb  D Rm2
% (Rm) R(b) Rm Rm
1 11.0 12.0 0.67 1.33 0.89 1.77
2 10.5 11.0 0.17 0.33 0.06 0.11
3 9.5 9.0 −0.83 −1.67 1.39 2.79
31.0 32.0 2.34 4.67
Average Rb = 10.33
Average Rm = 10.67
Covariance =
∑ (Rm - Rm )(Rb - Rb )
N
2.34
Covariance = = 0.78
3
Variance (σ m 2) =
∑ (Rm - Rm )2
N
4.67
= = 1.557
3
0.78
β= = 0.50
1.557
11. Characteristic line is given by

αi+ βiRm
βi = xy − n x y
x 2 − n(x) 2
αi = y − β x
Return Return xy x2 (x- x ) (x- x) 2 (y- y ) (y- y ) 2
on A on
(Y) market
(X)
12 8 96 64 2.25 5.06 5.67 32.15
15 12 180 144 6.25 39.06 8.67 75.17
11 11 121 121 5.25 27.56 4.67 21.81
2 -4 -8 16 -9.75 95.06 -4.33 18.75
10 9.5 95 90.25 3.75 14.06 3.67 13.47
-12 -2_ 24 4 -7.75 60.06 -18.33 335.99
38 34.5 508 439.25 240.86 497.34
y = 38 = 6.33
6
x = 34.5 6 = 5.75
xy − n x y 508 − 6 (5.75) (6.33) 508 − 218.385
β i= 2 = 2
=
x − n( x) 2
439.25 − 6(5.75) 439.25 −198.375
289.615
= = 1.202
240.875
 = y -  x = 6.33 – 1.202 (5.75) = - 0.58
Hence the characteristic line is -0.58 + 1.202 (R m)
240.86
Total Risk of Market = σ m 2 = ( x - x ) 2 = = 40.14(%)
n 6
497.34
Total Risk of Stock = = 82.89 (%)
6
Systematic Risk = βi 2 σ m2 = (1.202) 2 x 40.14 = 57.99(%)
Unsystematic Risk is = Total Risk – Systematic Risk

= 82.89 - 57.99 = 24.90(%)
12. (i)
Period R X RM R X − R X RM − RM (R X )(
− R X RM − RM ) (R M − RM )
2
1 20 22 5 10 50 100
2 22 20 7 8 56 64
3 25 18 10 6 60 36
4 21 16 6 4 24 16
5 18 20 3 8 24 64
6 -5 8 -20 -4 80 16
7 17 -6 2 -18 -36 324
8 19 5 4 -7 -28 49
9 -7 6 -22 -6 132 36
10 20 11 5 -1 -5 1
150 120 357 706
ΣR X ΣRM  (R X − R X )(R M − R M )  (R M − R M ) 2
R X = 15 R M = 12
2
 −

  RM − RM 
  706
2 M = n = 10 = 70.60
 −
 −

  R X − R X  R M − R M 
  357
CovX M= n = 10 = 35.70
Cov X M m 35.70
Betax = = = 0.505
 2M 70.60
Alternative Solution
Period X Y Y2 XY
1 20 22 484 440
2 22 20 400 440
3 25 18 324 450
4 21 16 256 336
5 18 20 400 360
6 -5 8 64 -40
7 17 -6 36 -102
8 19 5 25 95
9 -7 6 36 -42
10 20 11 121 220
150 120 2146 2157
X = 15 Y = 12
XY - n X Y
=
X 2 - n(X)2
2157 - 10 × 15 × 12 357
= = = 0.506
2146 - 10 × 12 × 12 706
(ii) R X = 15 R M = 12
y =  + x
15 =  + 0.505  12
Alpha () = 15 – (0.505  12) = 8.94%
Characteristic line for security X =  +   RM
Where, RM = Expected return on Market Index
Characteristic line for security X = 8.94 + 0.505 R M
13. (a) The Betas of two stocks:
Aggressive stock - (40% - 4%)/(25% - 7%) = 2
Defensive stock - (18% - 9%)/(25% - 7%) = 0.50
Alternatively, it can also be solved by using the Characteristic Line Relationship as
follows:
Rs = α + βRm
Where
α = Alpha
β = Beta
Rm= Market Return
For Aggressive Stock

4% = α + β(7%)
40% = α + β(25%)
36% = β(18%)
β=2
For Defensive Stock
9% = α + β(7%)
18% = α + β(25%)
9% = β(18%)
β =0.50
(b) Expected returns of the two stocks:-
Aggressive stock - 0.5 x 4% + 0.5 x 40% = 22%
Defensive stock - 0.5 x 9% + 0.5 x 18% = 13.5%
(c) Expected return of market portfolio = 0.5 x 7% + 0.5% x 25% = 16%
 Market risk prem. = 16% - 7.5% = 8.5%
 SML is, required return = 7.5% + βi 8.5%
(d) Rs = α + βRm
For Aggressive Stock
22% = α A + 2(16%)
αA = -10%
For Defensive Stock
13.5% = α D + 0.50(16%)
αD = 5.5%
14. (i) Sensitivity of each stock with market is given by its beta.
Standard deviation of market Index = 15%
Variance of market Index = 0.0225
Beta of stocks = σ i r/ σ m
A = 20 × 0.60/15 = 0.80
B = 18 × 0.95/15 = 1.14
C = 12 × 0.75/15 = 0.60
(ii) Covariance between any 2 stocks = β1β 2 σ 2m
Covariance matrix
Stock/Beta 0.80 1.14 0.60

A 400.000 205.200 108.000
B 205.200 324.000 153.900
C 108.000 153.900 144.000
(iii) Total risk of the equally weighted portfolio (Variance) = 400(1/3) 2 + 324(1/3) 2 +
144(1/3) 2 + 2 (205.20)(1/3)2 + 2(108.0)(1/3) 2 + 2(153.900) (1/3) 2 = 200.244
0.80 + 1.14 + 0.60
(iv) β of equally weighted portfolio = β p =  β i/N =
3
= 0.8467
(v) Systematic Risk β P2 σ m2 = (0.8467)2 (15)2 =161.302
Unsystematic Risk = Total Risk – Systematic Risk

= 200.244 – 161.302 = 38.942
15. (i) Mr. X’s position in the two securities are +1.50 in security A and -0.5 in security B.
Hence the portfolio sensitivities to the two factors:-
b prop. 1 =1.50 x 0.80 + (-0.50 x 1.50) = 0.45
b prop. 2 = 1.50 x 0.60 + (-0.50 x 1.20) = 0.30
(ii) Mr. X’s current position:-
Security A ` 3,00,000 / ` 1,00,000 = 3
Security B -` 1,00,000 / ` 1,00,000 = -1
Risk free asset -` 100000 / ` 100000 = -1
b prop. 1 = 3.0 x 0.80 + (-1 x 1.50) + (- 1 x 0) = 0.90
b prop. 2 = 3.0 x 0.60 + (-1 x 1.20) + (-1 x 0) = 0.60
(iii) Expected Return = Risk Free Rate of Return + Risk Premium
Let λ1 and λ2 are the Value Factor 1 and Factor 2 respectively.
Accordingly
15 = 10 + 0.80 λ 1 + 0.60 λ2
20 = 10 + 1.50 λ 1 + 1.20 λ2
On solving equation, the value of λ 1 = 0, and Securities A & B shall be as follows:
Security A
Total Return = 15%
Risk Free Return = 10%
Risk Premium = 5%
Security B
Total Return = 20%
Risk Free Return = 10%
Risk Premium = 10%
16. Market Risk Premium (A) = 14% – 7% = 7%
Share Beta Risk Premium Risk Free Return Return
(Beta x A) % Return % % `
Oxy Rin Ltd. 0.45 3.15 7 10.15 8,120
Boxed Ltd. 0.35 2.45 7 9.45 14,175
Square Ltd. 1.15 8.05 7 15.05 33,863
Ellipse Ltd. 1.85 12.95 7 19.95 89,775
Total Return 1,45,933
Total Investment ` 9,05,000

` 1,45,933
(i) Portfolio Return =  100 = 16.13%
` 9,05,000
(ii) Portfolio Beta

Portfolio Return = Risk Free Rate + Risk Premium х β = 16.13%
7% + 7 = 16.13%
β = 1.30
Alternative Approach
First we shall compute Portfolio Beta using the weighted average method as follows:
0.80 1.50 2.25 4.50
BetaP = 0.45X + 0.35X + 1.15X + 1.85X
9.05 9.05 9.05 9.05
= 0.45x0.0884+ 0.35X0.1657+ 1.15X0.2486+ 1.85X0.4972 = 0.0398+ 0.058 + 0.2859 +
0.9198 = 1.3035
Accordingly,
(i) Portfolio Return using CAPM formula will be as follows:
RP= RF + BetaP(RM – RF)
= 7% + 1.3035(14% - 7%) = 7% + 1.3035(7%)
= 7% + 9.1245% = 16.1245%
(ii) Portfolio Beta
As calculated above 1.3035
17. (i) Variance of Returns
Cov (i, j)
Cor i,j =
σ iσ j
Accordingly, for MFX

Cov (X,X)
1=
σ σ
X X
σ 2X = 4.800
Accordingly, for MFY

Cov (Y,Y)
1=
σ σ
Y Y
σ 2Y = 4.250
Accordingly, for Market Return

Cov (M,M)
1=
σ σ
M M
σ M2 = 3.100
(ii) Portfolio return, beta, variance and standard deviation

1,20,000
Weight of MFX in portfolio = =0.60
2,00,000
80,000
Weight of MFY in portfolio = =0.40
2,00,000
Accordingly Portfolio Return
0.60 × 15% + 0.40 × 14% = 14.60%
Beta of each Fund
Cov (Fund,Market )
β=
Varianceof Market
3.370
β = = 1.087
X 3.100
2.800
β = = 0.903
Y 3.100
Portfolio Beta
0.60 x 1.087 + 0.40 x 0.903 = 1.013
Portfolio Variance
σ 2XY = w 2X σ 2X + w 2Y σ 2Y + 2 w X w Y Cov X,Y
= (0.60) 2 (4.800) + (0.40) 2 (4.250) + 2(0.60) (0.40) (4.300)
= 4.472
Or Portfolio Standard Deviation
σ XY = 4.472 = 2.115
(iii) Expected Return, Systematic and Unsystematic Risk of Portfolio
Portfolio Return = 10% + 1.0134(12% - 10%) = 12.03%
MF X Return = 10% + 1.087(12% - 10%) = 12.17%
MF Y Return = 10% + 0.903(12% - 10%) = 11.81%
Systematic Risk = β 2 σ 2
Accordingly,
Systematic Risk of MFX = (1.087) 2 x 3.10 = 3.663
Systematic Risk of MFY = (0.903)2 x 3.10 = 2.528

Systematic Risk of Portfolio = (1.013)2 x 3.10 = 3.181
Unsystematic Risk = Total Risk – Systematic Risk
Accordingly,
Unsystematic Risk of MFX = 4.80 – 3.663 = 1.137
Unsystematic Risk of MFY = 4.250 – 2.528 = 1.722
Unsystematic Risk of Portfolio = 4.472 – 3.181 = 1.291
(iv) Sharpe and Treynor Ratios and Alpha
Sharpe Ratio
15% - 10%
MFX = = 2.282
4.800
14% - 10%
MFY = = 1.94
4.250
14.6% - 10%
Portfolio = = 2.175
2.115
Treynor Ratio
15% - 10%
MFX = = 4.60
1.087
14% - 10%
MFY = = 4.43
0.903
14.6% - 10%
Portfolio = = 4.54
1.0134
Alpha
MFX = 15% - 12.17% = 2.83%
MFY = 14% - 11.81% = 2.19%
Portfolio = 14.6% - 12.03% = 2.57%
18. Capital Asset Pricing Model (CAPM) formula for calculation of expected rate of return is
ER = Rf + β (Rm – Rf)
ER = Expected Return
β = Beta of Security
Rm = Market Return
Rf = Risk free Rate
= 10 + [1.2 (15 – 10)]
= 10 + 1.2 (5)
= 10 + 6 = 16% or 0.16
Applying dividend growth mode for the calculation of per share equilibrium price:-
D1
ER = +g
P0
3(1.12) 3.36
or 0.16 = + 0.12 or 0.16 – 0.12 =
P0 P0
3.36
or 0.04 P0 = 3.36 or P0 = = ` 84
0.04
Therefore, equilibrium price per share will be ` 84.
19. First we shall compute the β of Security X.
Coupon Payment 7
Risk Free Rate = = = 5%
Current Market Price 140
Assuming equilibrium return to be equal to CAPM return then:

15% = Rf + βX(Rm- Rf)
15%= 5% + β X(15%- 5%)
βX = 1
or it can also be computed as follows:
R m 15%
= =1
R s 15%
(i) Standard Deviation of Market Return

Cov X,m 225%
βm = = =1
m2 m2
σ2m = 225
σm = 225 = 15%
(ii) Standard Deviation of Security Return

X 
βX =  Xm = X  0.75 =1
m 15
15
σX = = 20%
0.75
20. CAPM = Rf+ β (Rm –Rf)
Accordingly
RABC = Rf+1.2 (Rm – Rf) = 19.8
RXYZ = Rf+ 0.9 (Rm – Rf) = 17.1
19.8 = Rf+1.2 (Rm – Rf) ------(1)
17.1 = Rf+0.9 (Rm – Rf) ------(2)
Deduct (2) from (1)
2.7 = 0.3 (Rm – R f)
Rm – Rf = 9
R f = Rm – 9
Substituting in equation (1)
19.8 = (Rm – 9) + 1.2 (Rm – Rm+ 9)
19.8 = Rm - 9 + 10.8
19.8 = Rm+1.8
Then Rm=18% and R f= 9%
Security Market Line
= Rf + β (Market Risk Premium)
= 9% + β  9%
21. (i) A Ltd. has lower return and higher risk than B Ltd. investing in B Ltd. is better than in
A Ltd. because the returns are higher and the risk, lower. However, investing in both
will yield diversification advantage.
(ii) rAB = .22  0.7 + .24  0.3 = 22.6%
σ 2AB = 0.402 X 0.72 + 0.382 X 0.32 + 2X 0.7 X 0.3 X 0.72 X 0.40 X 0.38 = 0.1374
 AB =  2AB = .1374 = .37 = 37% *
* Answer = 37.06% is also correct and variation may occur due to approximation.
(iii) This risk-free rate will be the same for A and B Ltd. Their rates of return are given as
follows:
rA = 22 = r f + (rm – rf) 0.86
rB = 24 = r f + (rm – rf) 1.24
rA – rB = –2 = (rm – rf) (–0.38)
rm – rf = –2/–0.38 = 5.26%
rA = 22 = r f + (5.26) 0.86
rf = 17.5%*
rB = 24 = r f + (5.26) 1.24
rf = 17.5%*
rm – 17.5 = 5.26
rm = 22.76%**
*Answer = 17.47% might occur due to variation in approximation.
**Answer may show small variation due to approximation. Exact answer is 22.73%.
(iv) AB = A  WA + B  WB
= 0.86  0.7 + 1.24  0.3 = 0.974
22. (i) Computation of Beta of Portfolio
Investment No. of Market Market Dividend Dividend Composition β Weighted

shares Price Value Yield β
I 60,000 4.29 2,57,400 19.50% 50,193 0.2339 1.16 0.27
II 80,000 2.92 2,33,600 24.00% 56,064 0.2123 2.28 0.48
III 1,00,000 2.17 2,17,000 17.50% 37,975 0.1972 0.90 0.18
IV 1,25,000 3.14 3,92,500 26.00% 1,02,050 0.3566 1.50 0.53
11,00,500 2,46,282 1.0000 1.46
2,46,282
Return of the Portfolio = 0.2238
11,00,500
Beta of Port Folio 1.46

Market Risk implicit
0.2238 = 0.11 + β× (0.19 – 0.11)
Or, 0.08 β + 0.11 = 0.2238

0.2238 − 0.11
β= = 1.42
0.08
Market β implicit is 1.42 while the port folio β is 1.46. Thus the portfolio is marginally
risky compared to the market.
(ii) The decision regarding change of composition may be taken by comparing the
dividend yield (given) and the expected return as per CAPM as follows:
Expected return Rs as per CAPM is:
Rs = IRF + (RM – I RF)β
For investment I Rs = IRF + (RM – IRF)β
= .11 + (.19 - .11) 1.16
= 20.28%
For investment II, R s = .11 + (.19 - .11) 2.28 = 29.24%
For investment III, Rs = .11 + (.19 - .11) .90
= 18.20%
For investment IV, Rs = .11 + (.19 - .11) 1.50
= 23%
Comparison of dividend yield with the expected return R s shows that the dividend
yields of investment I, II and III are less than the corresponding R s,. So, these
investments are over-priced and should be sold by the investor. However, in case of
investment IV, the dividend yield is more than the corresponding R s, so, XYZ Ltd.
should increase its proportion.
23. With 20% investment in each MF Portfolio Beta is the weighted average of the Betas of
various securities calculated as below:
(i)
Investment Beta (β) Investment Weighted
(` Lacs) Investment
A 1.6 20 32
B 1.0 20 20
C 0.9 20 18
D 2.0 20 40
E 0.6 20 12
100 122
Weighted Beta (β) = 1.22
(ii) With varied percentages of investments portfolio beta is calculated as follows:

Investment Beta (β) Investment Weighted
(` Lacs) Investment
A 1.6 15 24
B 1.0 30 30
C 0.9 15 13.5
D 2.0 30 60
E 0.6 10 6
100 133.5
Weighted Beta (β) = 1.335
(iii) Expected return of the portfolio with pattern of investment as in case (i)
= 12% × 1.22 i.e. 14.64%
Expected Return with pattern of investment as in case (ii) = 12% × 1.335 i.e., 16.02%.
24. (a) Let the weight of stocks of Economy A is expressed as w, then
(1- w)×10.0 + w ×15.0 = 10.5
i.e. w = 0.1 or 10%.
(b) Variance of portfolio shall be:
(0.9)2 (0.16) 2 + (0.1)2 (0.30) 2+ 2(0.9) (0.1) (0.16) (0.30) (0.30) = 0.02423
Standard deviation is (0.02423)½= 0.15565 or 15.6%.
(c) The Sharpe ratio will improve by approximately 0.04, as shown below:
Expected Return - RiskFreeRate of Return
Sharpe Ratio =
Standard Deviation
10 - 3
Investment only in developed countries: = 0.437
16
10.5 - 3
With inclusion of stocks of Economy A: = 0.481
15.6
25. (i) Computation of Expected Return from Portfolio
Security Beta Expected Return (r) Amount Weights wr

(β) as per CAPM (` Lakhs) (w)
Moderate 0.50 8%+0.50(10% - 8%) = 9% 60 0.115 1.035
Better 1.00 8%+1.00(10% - 8%) = 10% 80 0.154 1.540
Good 0.80 8%+0.80(10% - 8%) = 9.60% 100 0.192 1.843
Very Good 1.20 8%+1.20(10% - 8%)=10.40% 120 0.231 2.402
Best 1.50 8%+1.50(10% - 8%) = 11% 160 0.308 3.388
Total 520 1 10.208
Thus Expected Return from Portfolio 10.208% say 10.21%.

Alternatively, it can be computed as follows:
60 80 100 120 160
Average β = 0.50 x + 1.00 x + 0.80 x + 1.20 x + 1.50 x = 1.104
520 520 520 520 520
As per CAPM
= 0.08 + 1.104(0.10 – 0.08) = 0.10208 i.e. 10.208%
(ii) As computed above the expected return from Better is 10% same as from Nifty, hence
there will be no difference even if the replacement of security is made. The main logic
behind this neutrality is that the beta of security ‘Better’ is 1 which clearly indicates
that this security shall yield same return as market return.
26.
Particulars of Securities Cost ` Dividend Capital gain

Gold Ltd. 10,000 1,725 −200
Silver Ltd. 15,000 1,000 1,200
Bronz Ltd. 14,000 700 6,000
GOI Bonds 36,000 3,600 −1,500
Total 75,000 7,025 5,500
Expected rate of return on market portfolio

Dividend Earned + Capital appreciation
× 100
Initial investment
` 7,025 + ` 5,500
=  100 = 16.7%
` 75,000
Risk free return

0.6 + 0.8 + 0.6 + 0.01
Average of Betas = = Average of Betas* = 0.50
4
Average return = Risk free return + Average Betas (Expected return – Risk free return)
15.7 = Risk free return + 0.50 (16.7 – Risk free return)
Risk free return = 14.7%
* Alternatively, it can also be calculated through Weighted Average Beta.
Expected Rate of Return for each security is
Rate of Return = Rf + B (Rm – Rf)
Gold Ltd. = 14.7 + 0.6 (16.7 – 14.7) = 15.90%
Silver Ltd. = 14.7 + 0.8 (16.7 – 14.7) = 16.30%
Bronz Ltd. = 14.7 + 0.6 (16.7 – 14.7) = 15.90%
GOI Bonds = 14.7 + 0.01 (16.7 – 14.7) = 14.72%
* Alternatively, it can also be computed by using Weighted Average Method.
27. (i) Expected rate of return
Total Investments Dividends Capital Gains

Epsilon Ltd. 25 2 25
Sigma Ltd. 35 2 25
Omega Ltd. 45 2 90
GOI Bonds 1,000 140 _5
1,105 146 145
146 + 145
Expected Return on market portfolio= = 26.33%
1105
CAPM E(Rp) = RF + β [E(RM) – RF]
Epsilon Ltd 14+0.8 [26.33-14] = 14+9.86 = 23.86%

Sigma Ltd. 14+0.7 [26.33-14] = 14+8.63 = 22.63%
Omega Ltd. 14+0.5 [26.33-14] = 14+6.17 = 20.17%
GOI Bonds 14+0.01 [26.33-14] = 14+0.12 = 14.12%
(ii) Average Return of Portfolio

23.86 + 22.63 + 20.17 + 14.12 80.78
= = 20.20%
4 4
0.8 + 0.7 + 0.5 + 0.01 2.01
Alternatively, = = 0.5025
4 4
14 + 0.5025 (26.33 - 14) = 14+ 6.20 = 20.20%
28. Calculation of expected return on market portfolio (R m)
Investment Cost (`) Dividends ( `) Capital Gains ( `)

Shares X 8,000 800 200
Shares Y 10,000 800 500
Shares Z 16,000 800 6,000
PSU Bonds 34,000 3,400 –1,700
68,000 5,800 5,000
5,800 + 5,000
Rm =  100 = 15.88%
68,000
Calculation of expected rate of return on individual security:

Security
Shares X 15 + 0.8 (15.88 – 15.0) = 15.70%

Shares Y 15 + 0.7 (15.88 – 15.0) = 15.62%
Shares Z 15 + 0.5 (15.88 – 15.0) = 15.44%
PSU Bonds 15 + 0.2 (15.88 – 15.0) = 15.18%
Calculation of the Average Return of the Portfolio:

15.70 + 15.62 + 15.44 + 15.18
= = 15.49%.
4
29. On the basis of existing and revised factors, rate of return and price of share is to be
calculated.
Existing rate of return
= R f + Beta (R m – R f ) = 12% + 1.4 (6%) = 20.4%
Revised rate of return
= 10% + 1.25 (4%) = 15%
Price of share (original)
D (1 + g) 2 (1.05) 2.10
Po = = = = Rs. 13.63
K e - g .204 - .05 .154
Price of share (Revised)

2 (1.09) 2.18
Po = = = Rs. 36.33
.15 - .09 .06
In case of existing market price of ` 25 per share, rate of return (20.4%) and possible
equilibrium price of share at ` 13.63, this share needs to be sold because the share is
overpriced (` 25 – 13.63) by ` 11.37. However, under the changed scenario where growth of
dividend has been revised at 9% and the return though decreased at 15% but the possible
price of share is to be at ` 36.33 and therefore, in order to expect price appreciation to `
36.33 the investor should hold the shares, if other things remain the same
30. On the basis of existing and revised factors, rate of return and price of share is to be
calculated.
Existing rate of return
= Rf + Beta (Rm – Rf)
= 12% + 1.3 (5%) = 18.5%
Revised rate of return
= 10% + 1.4 (4%) = 15.60%
Price of share (original)
D (1 + g) 3 (1.09) 3.27
P = = = = ` 34.42
o K -g 0.185 - 0.09 0.095
e
Price of share (Revised)

2.50 (1.07) 2.675
P = = = ` 31.10
o 0.156 - 0.07 0.086
Market price of share of ` 40 is higher in comparison to current equilibrium price of ` 34.42

and revised equity price of ` 31.10. Under this situation investor should sell the share.
31. (i) Investment committed to each security would be:-
A B C Total
(`) (`) (`) (`)
Portfolio X 1,500 2,000 1,500 5,000
Portfolio Y 600 1,500 900 3,000
Combined Portfolio 2,100 3,500 2,400 8,000
 Stock weights 0.26 0.44 0.30
(ii) The equation of critical line takes the following form:-

WB = a + bWA
Substituting the values of WA & WB from portfolio X and Y in above equation, we get
0.40 = a + 0.30b, and
0.50 = a + 0.20b
Solving above equation we obtain the slope and intercept, a = 0.70 and b= -1 and thus,
the critical line is
WB = 0.70 – WA
If half of the funds is invested in security A then,
WB = 0.70 – 0.50 = 0.20
Since WA + WB + WC = 1
WC = 1 - 0.50 – 0.20 = 0.30
 Allocation of funds to security B = 0.20 x 8,000 = ` 1,600, and
Security C = 0.30 x 8,000 = ` 2,400
32. Workings:
Calculation of return on portfolio for 2009-10 (Calculation in
` / share)
M N
Dividend received during the year 10 3
Capital gain/loss by 31.03.10
Market value by 31.03.10 220 290
Cost of investment 200 300

Gain/loss 20 (-)10
Yield 30 (-)7
Cost 200 300
% return 15% (-)2.33%
Weight in the portfolio 57 43
Weighted average return 7.55%
Calculation of estimated return for 2010-11
Expected dividend 20 3.5
Capital gain by 31.03.11
(220x0.2)+ (250x0.5)+(280x0.3) – 220=(253-220) 33 -
(290x0.2)+(310x0.5)+(330x0.3) – 290= (312 – 290) - 22
Yield 53 25.5
*Market Value 01.04.10 220 290
% return 24.09% 8.79%
*Weight in portfolio (1,000x220): (500x290) 60.3 39.7
Weighted average (Expected) return 18.02%
(*The market value on 31.03.10 is used as the base for
calculating yield for 10-11)
(i) Average Return from Portfolio for the year ended 31.03.2010 is 7.55%.
(ii) Expected Average Return from portfolio for the year 2010-11 is 18.02%
(iii) Calculation of Standard Deviation
M Ltd.
Exp. Exp. Exp. Exp Prob. (1) Dev. Square (2) X (3)
market gain div. Yield Factor X(2) (PM - PM ) of dev.
value (1) (2) (3)
220 0 20 20 0.2 4 -33 1089 217.80
250 30 20 50 0.5 25 -3 9 4.50
280 60 20 80 0.3 24 27 729 218.70
53 σ 2M = 441.00
Standard Deviation (σ M) 21
N Ltd.
Exp. Exp. Exp. Exp Prob. (1) Dev. Square (2) X (3)
market gain div. Yield Factor X(2) (PN- PN ) of dev.
value (1) (2) (3)
290 0 3.5 3.5 0.2 0.7 -22 484 96.80
310 20 3.5 23.5 0.5 11.75 -2 4 2.00
330 40 3.5 43.5 0.3 13.05 18 324 97.20
25.5 σ2N = 196.00
Standard Deviation (σ N) 14
Share of company M Ltd. is more risky as the S.D. is more than company N Ltd.
33. Expected Return on stock A = E (A) =  PA

i=G,S,R i i
(G,S & R, denotes Growth, Stagnation and Recession )
(0.40)(25) + 0.30(10)+ 0.30(-5) = 11.5%
Expected Return on ‘B’
(0.40×20) + (0.30×15) +0.30× (-8)=10.1%
Expected Return on Market index
(0.40 × 18) + (0.30 × 13) + 0.30 × (-3) =10.2%
Variance of Market index
(18 - 10.2)2 (0.40) + (13 - 10.2)2 (0.30) + (-3 - 10.2)2 (0.30)
= 24.34 + 2.35 + 52.27 = 78.96%
Covariance of stock A and Market Index M
Cov. (AM) =  ([A - E(A)] [Mi - E(M)]Pi

i=G,S,R i
(25 -11.5) (18 - 10.2)(0.40) + (10 - 11.5) (13 - 10.2) (0.30) + (-5-11.5) (-3-10.2)(0.30)
= 42.12 + (-1.26) + 65.34=106.20
Covariance of stock B and Market index M
(20-10.1) (18-10.2)(0.40)+(15-10.1)(13-10.2)(0.30) + (-8-10.1)(-3-10.2)(0.30)= 30.89 + 4.12
+ 71.67=106.68
CoV(AM) 106.20
Beta for stock A = = = 1.345
VAR(M) 78.96
CoV(BM) 106.68
Beta for Stock B = = =1.351
VarM 78.96
Required Return for A
R (A) = Rf + β (M-Rf)
11% + 1.345(10.2 - 11) % = 9.924%
Required Return for B
11% + 1.351 (10.2 – 11) % = 9.92%
Alpha for Stock A
E (A) – R (A) i.e. 11.5 % – 9.924% = 1.576%
Alpha for Stock B
E (B) – R (B) i.e. 10.1% - 9.92% = 0.18%
Since stock A and B both have positive Alpha, therefore, they are UNDERPRICED. The
investor should make fresh investment in them.
34. (i) Portfolio Beta
0.20 x 0.40 + 0.50 x 0.50 + 0.30 x 1.10 = 0.66
(ii) Residual Variance
To determine Residual Variance first of all we shall compute the Systematic Risk as follows:
β2A  σ M
2
= (0.40)2(0.01) = 0.0016
βB2  σ M
2
= (0.50)2(0.01) = 0.0025
β2C  σ M
2
= (1.10)2(0.01) = 0.0121
Residual Variance
A 0.015 – 0.0016 = 0.0134
B 0.025 – 0.0025 = 0.0225
C 0.100 – 0.0121 = 0.0879
(iii) Portfolio variance using Sharpe Index Model
Systematic Variance of Portfolio = (0.10) 2 x (0.66)2 = 0.004356
Unsystematic Variance of Portfolio = 0.0134 x (0.20) 2 + 0.0225 x (0.50) 2 + 0.0879 x

(0.30)2 = 0.014072
Total Variance = 0.004356 + 0.014072 = 0.018428
(iv) Portfolio variance on the basis of Markowitz Theory
2
= (wA x wAx σ A ) + (wA x wBxCovAB) + (wA x wCxCovAC) + (wB x wAxCovAB) + (wB x wBx
σ B2 ) + (wB x wCxCovBC) + (wC x wAxCovCA) + (wC x wBxCovCB) + (wC x wCx σ 2c )
= (0.20 x 0.20 x 0.015) + (0.20 x 0.50 x 0.030) + (0.20 x 0.30 x 0.020) + (0.20 x 0.50
x 0.030) + (0.50 x 0.50 x 0.025) + (0.50 x 0.30 x 0.040) + (0.30 x 0.20 x 0.020) + (0.30
x 0.50 x 0.040) + (0.30 x 0.30 x 0.10)
= 0.0006 + 0.0030 + 0.0012 + 0.0030 + 0.00625 + 0.0060 + 0.0012 + 0.0060 + 0.0090
= 0.0363
35. Securities need to be ranked on the basis of excess return to beta ratio from highest to the
lowest.
Security Ri i Ri - Rf Ri - Rf
i
A 15 1.5 8 5.33
B 12 2 5 2.5
C 10 2.5 3 1.2
D 9 1 2 2
E 8 1.2 1 0.83
F 14 1.5 7 4.67
Ranked Table:
Sec (R i - R f ) x  i N
(R i - R f ) x  i  i2 N
 i2
urity
R i - R f i  2 ei
 2 ei

e=i  2 ei  2 ei

e=i
2
ei
Ci
A 8 1.5 40 0.30 0.30 0.056 0.056 1.923

F 7 1.5 30 0.35 0.65 0.075 0.131 2.814
B 5 2 20 0.50 1.15 0.20 0.331 2.668
D 2 1 10 0.20 1.35 0.10 0.431 2.542
C 3 2.5 30 0.25 1.60 0.208 0.639 2.165
E 1 1.2 20 0.06 1.66 0.072 0.711 2.047
CA = 10 x 0.30 / [1 + ( 10 x 0.056)] = 1.923

CF = 10 x 0.65 / [1 + ( 10 x 0.131)] = 2.814
CB = 10 x 1.15 / [1 + ( 10 x 0.331)] = 2.668
CD = 10 x 1.35 / [1 + ( 10 x 0.431)] = 2.542
CC = 10 x 1.60 / [1 + ( 10 x 0.639)] = 2.165
CE = 10 x 1.66 / [1 + ( 10 x 0.7111)] = 2.047
Cut off point is 2.814
Zi =  [
(
β i   R i - R f ) - C] 
σ 2 ei   βi  
 
1.5
ZA = (5.33 - 2.814) = 0.09435
40
1.5
ZF = ( 4.67 - 2.814) = 0.0928
30
XA = 0.09435 / [ 0.09435 + 0.0928] = 50.41%
XF = 0.0928 / [0.09435 + 0.0928] = 49.59%
Funds to be invested in security A & F are 50.41% and 49.59% respectively.

36. (i)
Security No. of Market Price (1) × (2) % to total (w) ß (x) wx
shares of Per Share
(1) (2)
VSL 10000 50 500000 0.4167 0.9 0.375
CSL 5000 20 100000 0.0833 1 0.083
SML 8000 25 200000 0.1667 1.5 0.250
APL 2000 200 400000 0.3333 1.2 0.400
1200000 1 1.108
Portfolio beta 1.108
(ii) Required Beta 0.8
It should become (0.8 / 1.108) 72.2 % of present portfolio
If ` 12,00,000 is 72.20%, the total portfolio should be

` 12,00,000 × 100/72.20 or ` 16,62,050
Additional investment in zero risk should be (` 16,62,050 – ` 12,00,000) = ` 4,62,050
Revised Portfolio will be
Security No. of Market (1) × (2) % to ß (x) wx
shares Price of Per total
(1) Share (2) (w)
VSL 10000 50 500000 0.3008 0.9 0.271
CSL 5000 20 100000 0.0602 1 0.060
SML 8000 25 200000 0.1203 1.5 0.180
APL 2000 200 400000 0.2407 1.2 0.289
Risk free 46205 10 462050 0.2780 0 0
asset
1662050 1 0.800
(iii) To increase Beta to 1.2

Required beta 1.2
It should become 1.2 / 1.108 108.30% of present beta
If 1200000 is 108.30%, the total portfolio should be
1200000 × 100/108.30 or 1108033 say 1108030
Additional investment should be (-) 91967 i.e. Divest ` 91970 of Risk Free Asset
Revised Portfolio will be
Security No. of Market (1) × (2) % to total ß (x) wx
shares Price of Per (w)
(1) Share (2)
VSL 10000 50 500000 0.4513 0.9 0.406
CSL 5000 20 100000 0.0903 1 0.090
SML 8000 25 200000 0.1805 1.5 0.271
APL 2000 200 400000 0.3610 1.2 0.433
Risk free -9197 10 -91970 -0.0830 0 0
asset
1108030 1 1.20
Portfolio beta 1.20
xβ i i
37. βp = i=1
= 1.60 x 0.25 + 1.15 x 0.30 + 1.40 x 0.25 + 1.00 x 0.20

= 0.4 + 0.345 + 0.35 + 0.20 = 1.295
The Standard Deviation (Risk) of the portfolio is
= [(1.295) 2(18)2+(0.25)2(7)2+(0.30)2(11)2+(0.25)2(3)2+(0.20) 2(9)2)]
= [543.36 + 3.0625 + 10.89 + 0.5625 + 3.24] = [561.115] ½ = 23.69%
Alternative Answer
The variance of Security’s Return
2 = i2 2m + 2εi
Accordingly, variance of various securities
2 Weight(w) 2Xw
L (1.60)2 (18)2 + 72 = 878.44 0.25 219.61
M (1.15)2 (18)2 + 112 = 549.49 0.30 164.85
N (1.40)2 (18)2 + 32 = 644.04 0.25 161.01
K (1.00)2 (18)2 + 92 = 405.00 0.20 81
Variance 626.47
SD = 626.47 = 25.03
38. Return of the stock under APT

Factor Actual Expected Difference Beta Diff. х
value in % value in % Beta
GNP 7.70 7.70 0.00 1.20 0.00
Inflation 7.00 5.50 1.50 1.75 2.63
Interest rate 9.00 7.75 1.25 1.30 1.63
Stock index 12.00 10.00 2.00 1.70 3.40
Ind. Production 7.50 7.00 0.50 1.00 0.50
8.16
Risk free rate in % 9.25
Return under APT 17.41
V V
39. (i)  =   E
+ B  D
company equity V debt V
0 0
Note: Since debt is not given it is assumed that company debt capital is virtually
riskless.
If company’s debt capital is riskless than above relationship become:
VE
Here equity = 1.5; company = equity
V0
As debt = 0
VE = ` 60 lakhs.
VD = ` 40 lakhs.
V0 = ` 100 lakhs.
` 60 lakhs
company assets= 1.5 
` 100 lakhs
= 0.9
(ii) Company’s cost of equity = Rf + A  Risk premium
Where Rf = Risk free rate of return
A = Beta of company assets
Therefore, company’s cost of equity = 8% + 0.9  10 = 17% and overall cost of capital
shall be
60,00,000 40,00,000
= 17%× +8%×
100,00,000 100,00,000
= 10.20% + 3.20% = 13.40%

Alternatively it can also be computed as follows:
Cost of Equity = 8% + 1.5 x 10 = 23%
Cost of Debt = 8%
60,00,000 40,00,000
WACC (Cost of Capital) = 23%  + 8%  = 17%
1,00,00,000 1,00,00,000
In case of expansion of the company’s present business, the same rate of return i.e.
13.40% will be used. However, in case of diversification into new business the risk
profile of new business is likely to be different. Therefore, different discount factor has
to be worked out for such business.
40. (a) Method I
Stock’s return
Small cap growth = 4.5 + 0.80 x 6.85 + 1.39 x (-3.5) + 1.35 x 0.65 = 5.9925%
Small cap value = 4.5 + 0.90 x 6.85 + 0.75 x (-3.5) + 1.25 x 0.65 = 8.8525%
Large cap growth = 4.5 + 1.165 x 6.85 + 2.75 x (-3.5) + 8.65 x 0.65 = 8.478%
Large cap value = 4.5 + 0.85 x 6.85 + 2.05 x (-3.5) + 6.75 x 0.65 = 7.535%
Expected return on market index
0.25 x 5.9925 + 0.10 x 8.8525 + 0.50 x 8.478 + 0.15 x 7.535 = 7.7526%
Method II
Expected return on the market index
= 4.5% + [0.1x0.9 + 0.25x0.8 + 0.15x0.85 + 0.50x1.165] x 6.85 + [(0.75 x 0.10 +
1.39 x 0.25 + 2.05 x 0.15 + 2.75 x 0.5)] x (-3.5) + [{1.25 x 0.10 + 1.35 x 0.25 +
6.75 x 0.15 + 8.65 x 0.50)] x 0.65
= 4.5 + 6.85 + (-7.3675) + 3.77 = 7.7525%.
(b) Using CAPM,
Small cap growth = 4.5 + 6.85 x 0.80 = 9.98%
Small cap value = 4.5 + 6.85 x 0.90 = 10.665%
Large cap growth = 4.5 + 6.85 x 1.165 = 12.48%
Large cap value = 4.5 + 6.85 x 0.85 = 10.3225%
Expected return on market index
= 0.25 x 9.98 + 0.10 x 10.665 + 0.50 x 12.45 + 0.15 x 10.3225 = 11.33%
(c) Let us assume that Mr. Nirmal will invest X1% in small cap value stock and X 2% in
large cap growth stock
X1 + X2 = 1
0.90 X1 + 1.165 X2 = 1
0.90 X1 + 1.165(1 – X1) = 1
0.90 X1 + 1.165 – 1.165 X1 = 1
0.165 = 0.265 X 1
0.165
= X1
0.265
0.623 = X 1, X2 = 0.377
62.3% in small cap value
37.7% in large cap growth.
41. Sharpe Ratio S = (Rp – Rf)/σp
Treynor Ratio T = (Rp – Rf)/βp
Where,
Rp = Return on Fund
Rf = Risk-free rate
σp = Standard deviation of Fund
βp = Beta of Fund
Reward to Variability (Sharpe Ratio)
Mutual Rp Rf Rp – Rf σp Reward to Ranking
Fund Variability
A 15 6 9 7 1.285 2
B 18 6 12 10 1.20 3
C 14 6 8 5 1.60 1
D 12 6 6 6 1.00 5
E 16 6 10 9 1.11 4
Reward to Volatility (Treynor Ratio)

Mutual Rp Rf Rp – Rf βp Reward to Ranking
Fund Volatility
A 15 6 9 1.25 7.2 2
B 18 6 12 0.75 16 1
C 14 6 8 1.40 5.71 5
D 12 6 6 0.98 6.12 4
E 16 6 10 1.50 6.67 3
6
SECURITIZATION
LEARNING OUTCOMES
❑ Introduction
❑ Concept and Definition
❑ Benefits of Securitization
❑ Participants in Securitization
❑ Mechanism of Securitization
❑ Problems in Securitization
❑ Securitization Instruments
❑ Pricing of Securitization Instruments
❑ Securitization in India
1. INTRODUCTION
Some companies or firms who are involved in sending the money or making credit sale must have
a huge balance of receivables in their Balance Sheet. Though they have a huge receivable but still
they may face liquidity crunch to run their business. One way may to adopt borrowing route, but
this results in changing the debt equity ratio of the company which may not only be acceptable to
some stakeholders but also put companies to financial risk which affects the future borrowings by
the company. To overcome this problem the term ‘securitization’ was coined.
2. CONCEPT AND DEFINITION

The process of securitization typically involves the creation of pool of assets from the illiquid
financial assets, such as receivables or loans which are marketable. In other words, it is the
process of repackaging or rebundling of illiquid assets into marketable securities. These assets
can be automobile loans, credit card receivables, residential mortgages or any other form of future
receivables.
Features of Securitization
The securitization has the following features:
(i) Creation of Financial Instruments – The process of securities can be viewed as process of
creation of additional financial product of securities in market backed by collaterals.
(ii) Bundling and Unbundling – When all the assets are combined in one pool it is bundling and
when these are broken into instruments of fixed denomination it is unbundling.
(iii) Tool of Risk Management – In case of assets are securitized on non-recourse basis, then
securitization process acts as risk management as the risk of default is shifted.
(iv) Structured Finance – In the process of securitization, financial instruments are tailor
structured to meet the risk return trade of profile of investor, and hence, these securitized
instruments are considered as best examples of structured finance.
(v) Trenching – Portfolio of different receivable or loan or asset are split into several parts
based on risk and return they carry called ‘Tranche’. Each Trench carries a different level of
risk and return.
(vi) Homogeneity – Under each tranche the securities issued are of homogenous nature and
even meant for small investors who can afford to invest in small amounts.
3. BENEFITS OF SECURITIZATION
The benefits of securitization can be viewed from the angle of various parties involved as follows:
3.1 From the angle of originator

Originator (entity which sells assets collectively to Special Purpose Vehicle) achieves the following
benefits from securitization.
(i) Off – Balance Sheet Financing: When loan/receivables are securitized it releases a portion
of capital tied up in these assets resulting in off Balance Sheet financing leading to
improved liquidity position which helps in expanding the business of the company.
SECURITIZATION 76.3
(ii) More specialization in main business: By transferring the assets the entity could
concentrate more on core business as servicing of loan is transferred to SPV. Further, in
case of non-recourse arrangement even the burden of default is shifted.
(iii) Helps to improve financial ratios: Especially in case of Financial Institutions and Banks, it
helps to manage Capital –To-Weighted Asset Ratio effectively.
(iv) Reduced borrowing Cost: Since securitized papers are rated due to credit enhancement
even they can also be issued at reduced rate as of debts and hence the originator earns a
spread, resulting in reduced cost of borrowings.
3.2 From the angle of investor

Following benefits accrues to the investors of securitized securities.
1. Diversification of Risk: Purchase of securities backed by different types of assets provides
the diversification of portfolio resulting in reduction of risk.
2. Regulatory requirement: Acquisition of asset backed belonging to a particular industry say
micro industry helps banks to meet regulatory requirement of investment of fund in industry
specific.
3. Protection against default: In case of recourse arrangement if there is any default by any
third party then originator shall make good the least amount. Moreover, there can be
insurance arrangement for compensation for any such default.
4. PARTICIPANTS IN SECURITIZATION
Broadly, the participants in the process of securitization can be divided into two categories; one is
Primary Participant and the other is Secondary Participant.
4.1 Primary Participants

Primary Participants are main parties to this process. The primary participants in the process of
securitization are as follows:
(a) Originator: It is the initiator of deal or can be termed as securitizer. It is an entity which sells
the assets lying in its books and receives the funds generated through the sale of such assets. The
originator transfers both legal as well as beneficial interest to the Special Purpose Vehicle
(discussed later).
(b) Special Purpose Vehicle: Also, called SPV is created for the purpose of executing the deal.
Since issuer originator transfers all rights in assets to SPV, it holds the legal title of these asse ts. It
is created especially for the purpose of securitization only and normally could be in form of a
company, a firm, a society or a trust.
The main objective of creating SPV is to remove the asset from the Balance Sheet of Originator.
Since, SPV makes an upfront payment to the originator, it holds the key position in the overall
process of securitization. Further, it also issues the securities (called Asset Based Securities or
Mortgage Based Securities) to the investors.
(c) The Investors: Investors are the buyers of securitized papers which may be an individual, an
institutional investor such as mutual funds, provident funds, insurance companies, mutual funds,
Financial Institutions etc.
Since, they acquire a participating in the total pool of assets/receivable, they receive their money
back in the form of interest and principal as per the terms agreed.
4.2 Secondary Participants

Besides the primary participants other parties involved into the securitization process are as
follows:
(a) Obligors: Actually they are the main source of the whole securitization process. They are the
parties who owe money to the firm and are assets in the Balance Sheet of Originator. The amount
due from the obligor is transferred to SPV and hence they form the basis of securitization process
and their credit standing is of paramount importance in the whole process.
(b) Rating Agency: Since the securitization is based on the pools of assets rather than the
originators, the assets have to be assessed in terms of its credit quality and credit support
available. Rating agency assesses the following:
❑ Strength of the Cash Flow.
❑ Mechanism to ensure timely payment of interest and principle repayment.
❑ Credit quality of securities.
❑ Liquidity support.
❑ Strength of legal framework.
Although rating agency is secondary to the process of securitization but it plays a vital role.
(c) Receiving and Paying agent (RPA): Also, called Servicer or Administrator, it collects the
payment due from obligor(s) and passes it to SPV. It also follow up with defaulting borrower and if
required initiate appropriate legal action against them. Generally, an originator or its affiliates acts
as servicer.
(d) Agent or Trustee: Trustees are appointed to oversee that all parties to the deal perform in
the true spirit of terms of agreement. Normally, it takes care of interest of investors who acquires
the securities.
SECURITIZATION 76.5
(e) Credit Enhancer: Since investors in securitized instruments are directly exposed to
performance of the underlying and sometime may have limited or no recourse to the originator,
they seek additional comfort in the form of credit enhancement. In other words, they require credit
rating of issued securities which also empowers marketability of the securities.
Originator itself or a third party say a bank may provide this additional context called Credit
Enhancer. While originator provides his comfort in the form of over collateralization or cash
collateral, the third party provides it in form of letter of credit or surety bonds.
(f) Structurer: It brings together the originator, investors, credit enhancers and other parties to
the deal of securitization. Normally, these are investment bankers also called arranger of the deal.
It ensures that deal meets all legal, regulatory, accounting and tax laws requirements.
5. MECHANISM OF SECURITIZATION
Let us discuss briefly the steps in securitization mechanism:
5.1 Creation of Pool of Assets

The process of securitization begins with creation of pool of assets by segregation of assets
backed by similar type of mortgages in terms of interest rate, risk, maturity and concentration
units.
5.2 Transfer to SPV

One assets have been pooled, they are transferred to Special Purpose Vehicle (SPV) especially
created for this purpose.
5.3 Sale of Securitized Papers

SPV designs the instruments based on nature of interest, risk, tenure etc. based on pool of assets.
These instruments can be Pass Through Security or Pay Through Certificates, (discussed later).
5.4 Administration of assets

The administration of assets in subcontracted back to originator which collects principal and
interest from underlying assets and transfer it to SPV, which works as a conduct.
5.5 Recourse to Originator

Performance of securitized papers depends on the performance of underlying a ssets and unless
specified in case of default they go back to originator from SPV.
5.6 Repayment of funds

SPV will repay the funds in form of interest and principal that arises from the assets pooled.
5.7 Credit Rating to Instruments

Sometime before the sale of securitized instruments credit rating can be done to assess the risk of
the issuer.
The mechanism of Securitization has been shown below in form of a diagram.
6. PROBLEMS IN SECURITIZATION
Following are main problems faced in growth of Securitization of instruments especially in Indian
context:
6.1 Stamp Duty

Stamp Duty is one of the obstacle in India. Under Transfer of Property Act, 1882, a mortgage debt
stamp duty which even goes upto 12% in some states of India and this impeded the growth of
securitization in India. It should be noted that since pass through certificate does not evidence any
debt only able to receivable, they are exempted from stamp duty.
Moreover, in India, recognizing the special nature of securitized instruments in some states has
reduced the stamp duty on them.
6.2 Taxation
Taxation is another area of concern in India. In the absence of any specific provision relating to
securitized instruments in Income Tax Act experts’ opinion differ a lot. Some are of opinion that
SPV as a trustee is liable to be taxed in a representative capacity then other s are of view that
SECURITIZATION 76.7
instead of SPV, investors will be taxed on their share of income. Clarity is also required on the
issues of capital gain implications on passing payments to the investors.
6.3 Accounting
Accounting and reporting of securitized assets in the books of originator is another area of
concern. Although securitization is slated to be an off-balance sheet instrument but in true sense
receivables are removed from originator’s balance sheet. Problem arises especially when assets
are transferred without recourse.
6.4 Lack of standardization

Every originator following his own format for documentation and administration having lack of
standardization is another obstacle in the growth of securitization.
6.5 Inadequate Debt Market

Lack of existence of a well-developed debt market in India is another obstacle that hinders the
growth of secondary market of securitized or asset backed securities.
6.6 Ineffective Foreclosure laws

For many years efforts are on for effective foreclosure but still foreclosure laws are not supportive to
lending institutions and this makes securitized instruments especially mortgaged backed securities
less attractive as lenders face difficulty in transfer of property in event of default by the borrower.
7. SECURITIZATION INSTRUMENTS
On the basis of different maturity characteristics, the securitized instruments can be divided into
following three categories:
7.1 Pass Through Certificates (PTCs)

As the title suggests originator (seller of the assets) transfers the entire receipt of cash in the form
of interest or principal repayment from the assets sold. Thus, these securities represent direct
claim of the investors on all the assets that has been securitized through SPV.
Since all cash flows are transferred the investors carry proportional beneficial interest in the asset
held in the trust by SPV.
It should be noted that since it is a direct route any prepayment of principal is also proportionately
distributed among the securities holders. Further, due to these characteristics on completion of
securitization by the final payment of assets, all the securities are terminated simultaneously.
Skewness of cash flows occurs in early stage if principals are repaid before the scheduled time.
7.2 Pay Through Security (PTS)

As mentioned earlier, since, in PTCs all cash flows are passed to the performance of the
securitized assets. To overcome this limitation and limitation to single mature there is another
structure i.e. PTS.
In contrast to PTC in PTS, SPV debt securities are backed by the assets and hence it can
restructure different tranches from varying maturities of receivables.
In other words, this structure permits desynchronization of servicing of secu rities issued from cash
flow generating from the asset. Further, this structure also permits the SPV to reinvest surplus
funds for short term as per their requirement.
Since, in Pass Through, all cash flow immediately in PTS in case of early retirement of receivables
plus cash can be used for short term yield. This structure also provides the freedom to issue
several debt tranches with varying maturities.
7.3 Stripped Securities

Stripped Securities are created by dividing the cash flows associated with und erlying securities
into two or more new securities. Those two securities are as follows:
(i) Interest Only (IO) Securities
(ii) Principle Only (PO) Securities
As each investor receives a combination of principal and interest, it can be stripped into two
portion of Interest and Principle.
Accordingly, the holder of IO securities receives only interest while PO security holder receives
only principal. Being highly volatile in nature these securities are less preferred by investors.
In case yield to maturity in market rises, PO price tends to fall as borrower prefers to postpone the
payment on cheaper loans. Whereas if interest rate in market falls, the borrower tends to repay the
loans as they prefer to borrow fresh at lower rate of interest.
In contrast, value of IO’s securities increases when interest rate goes up in the market as more
interest is calculated on borrowings.
However, when interest rate due to prepayments of principals, IO’s tends to fall.
Thus, from the above, it is clear that it is mainly perception of investors that determines the prices
of IOs and Pos
8. PRICING OF THE SECURITIZED INSTRUMENTS

Pricing of securitized instruments is an important aspect of securitization. While pricing the
instruments, it is important that it should be acceptable to both originators as well as to the
investors. On the same basis pricing of securities can be divided into following two categories:
SECURITIZATION 76.9
8.1 From Originator’s Angle

From originator’s point of view, the instruments can be priced at a rate at which or iginator has to
incur an outflow and if that outflow can be amortized over a period of time by investing the amount
raised through securitization.
8.2 From Investor’s Angle

From an investor’s angle security price can be determined by discounting best estim ate of
expected future cash flows using rate of yield to maturity of a security of comparable security with
respect to credit quality and average life of the securities. This yield can also be estimated by
referring the yield curve available for marketable securities, though some adjustments is needed
on account of spread points, because of credit quality of the securitized instruments.
9. SECURITIZATION IN INDIA
It is the Citi Bank who pioneered the concept of securitization in India by bundling of auto loans
into securitized instruments.
Thereafter many organizations securitized their receivables. Although started with securitization of
auto loans it moved to other types of receivables such as sales tax deferrals, aircraft receivable
etc.
In order to encourage securitization, the Government has come out with Securitization and
Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, to
tackle menace of Non Performing Assets (NPAs) without approaching the Court.
With growing sophistication of financial products in Indian Capital Market, securitization has
occupied an important place.
As mentioned above, though, initially started with auto loan receivables, it has become an
important source of funding for micro finance companies and NBFCs and even now a days
commercial mortgage backed securities are also emerging.
The important highlight of the scenario of securitization in Indian Market is that it is dominated by a
few players e.g. ICICI Bank, HDFC Bank, NHB etc.
As per a report of CRISIL, securitization transactions in India scored to the highest level of
approximately ` 70000 crores, in Financial Year 2016. (Business Line, 15th June, 2016)
In order to further enhance the investor base in securitized debts, SEBI has allowed FPIs to invest
in securitized debt of unlisted companies upto a certain limit.
TEST YOUR KNOWLEDGE

1. Differentiate between PTS and PTC.
2. What are the main problems faced in securitisation especially in Indian context ?
ANSWERS/ SOLUTIONS
7
MUTUAL FUNDS
LEARNING OUTCOMES
❑ Basics of Mutual Funds
❑ Evolution of Mutual Funds
❑ Classification of Mutual Funds
❑ Types of Schemes
❑ Advantages of Mutual Fund
❑ Drawbacks of Mutual Fund
❑ Terms associated with Mutual Funds
1. INTRODUCTION
Mutual Fund is a trust that pools together the resources of investors to make a foray into
investments in the capital market thereby making the investor to be a part owner of the assets of
the mutual fund. The fund is managed by a professional money manager who invests the money
collected from different investors in various stocks, bonds or other securities according to specific
investment objectives as established by the fund. If the value of the mutual fund investments goes
up, the return on them increases and vice versa. The net income earned on the funds, along with
capital appreciation of the investment, is shared amongst the unit holders in proportion to the units
owned by them. Mutual Fund is therefore an indirect vehicle for the investor investing in capital
markets. In return for administering the fund and managing its investment portfolio, the fund
manager charges fees based on the value of the fund’s assets.
Pool their
Passed back to Investors money with
Returns Fund
How does a mutual fund work?

1.1 Mutual Benefits
Investing in mutual funds is an expert’s job in the present market scenario. A systematic
investment in this instrument is bound to give rich dividends in the long-term. That is why over 2
crore investors have faith in mutual funds.
1.2 What is a Mutual Fund
A mutual fund is a trust that pools the savings of a number of investors who share a common
financial goal. A mutual fund is the most suitable investment for the cautious investor as it offers
an opportunity to invest in a diversified professionally managed basket of securities at a relatively
low cost. So, we can say that Mutual Funds are trusts which pool resources from large number of
investors through issue of units for investments in capital market instruments such as shares,
debentures and bonds and money-market instruments such as commercial papers, certificate of
deposits and treasury bonds.
1.3 Who can invest in Mutual Funds
Anybody with an investible surplus of as little as a few thousand rupees can invest in mutual funds
by buying units of a particular mutual fund scheme that has a defined investment objective and
strategy.
1.4 How Mutual Funds work for you
The money collected from the investors is invested by a fund manager in different types of
securities. These could range from shares and debentures to money market instruments
depending upon the scheme’s stated objectives.
The income earned through these investments and capital appreciation realized by the scheme is
shared by its unit holders in proportion to the units owned by them. (please refer the diagram
above)
1.5 Should we invest in Stocks or Mutual Funds?
As soon as, you have set your goals and decided to invest in equity the question arises should you
invest in stocks or mutual funds? Well, you need to decide what kind of an investor you are.
MUTUAL FUNDS 77.3
First, consider if you have the kind of disposable income to invest in 15-20 stocks. That is how
many stocks you will have to invest in if you want to create a well-diversified portfolio. Remember
the familiar adage: Do not put all your eggs in one basket? If ` 5,000 were all you have to spare, it
would be impractical to invest it across many stocks.
Many beginners tend to focus on stocks that have a market price of less than ` 100 or ` 50; that
should never be a criterion for choosing a stock. Also, brokerage could eat into your returns if you
purchase small quantities of a stock.
On the other hand, you would be able to gain access to a wide basket of stocks for ` 5,000 if you
buy into a fund. Investing in funds would also be an easy way to build your equity portfolio over
time.
Let’s say you can afford to put away only ` 1,000 a month in the market. You can simply invest in
a fund every month through a Systematic Investment Plan (SIP) as a matter of financial discipline.
You can save yourself the trouble of scouting for a stock every month.
That brings us to the next point. Do you have the time to pick stocks? You need to invest a
considerable amount of time reading newspapers, magazines, annual reports, quarterly updates,
industry reports and talking to people who are familiar with industry practices. Else, you certainly
won’t catch a trend or pick a stock ahead of the market. How many great investors have you heard
of who have not made investing their full-time job?
Plus, you may have the time, but not the inclination. You have to be an active investor, which
means continuously monitor the stocks you pick and make changes – buy more, cut exposures –
depending upon the turn of events. These actions have costs as well. As you churn your portfolio,
you bear expenses such as capital gains tax. Funds do not pay capital gains tax when they sell a
stock.
All this assumes you know what you are doing and have the skill to pick the right stocks. Yo u are
likely to be better at investing in an industry you understand. Only, too bad if that industry appears
to be out of favour in the market.
If you love the thrill of the ups and downs in the stock market; if you find yourself turning to business
channels and business newspapers hoping that you can pick the next Infosys; if you have an instinct
for spotting stocks and, importantly, the discipline to act on it; if you have the emotional maturity to
cut your losses when you are ahead, then you can trust yourself to invest in stocks.
Otherwise, hand over your money to the professional. Mutual funds could be the best avenue for
the risk-averse Investors.
2. EVOLUTION OF THE INDIAN MUTUAL FUND INDUSTRY

The mutual fund industry in India started in 1963 with the formation of Unit Trust of India, at the
initiative of the Government of India and Reserve Bank of India. The history of mutual funds in
India can be broadly divided into four distinct phases.
First Phase – 1964-87

Unit Trust of India (UTI) was established in 1963 by an Act of Parliament. It was set up by the
Reserve Bank of India and functioned under the regulatory and administrative control of the
Reserve Bank of India. In 1978, UTI was de-linked from the RBI and the Industrial Development
Bank of India (IDBI) took over the regulatory and administrative control in place of RBI. The first
scheme launched by UTI was Unit Scheme 1964. At the end of 1988, UTI had ` 6,700 crores of
assets under management.
Second Phase – 1987-1993 (Entry of Public Sector Funds)
1987 marked the entry of non- UTI, public sector mutual funds set up by public sector banks, Life
Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC). SBI Mutual
Fund was the first non- UTI Mutual Fund established in June 1987 followed by Canbank Mutual
Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89), Indian Bank Mutual Fund (Nov 89),
Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92). LIC established its mutual fund in
June 1989 while GIC had set up its mutual fund in December 1990. At the end of 1993, the mutual
fund industry had assets under management of ` 47,004 crores.
Third Phase – 1993-2003 (Entry of Private Sector Funds)
With the entry of private sector funds in 1993, a new era started in the Indian mutual fund industry,
giving the Indian investors a wider choice of fund families. Also, 1993 was the year in which the
first Mutual Fund Regulations came into being, under which all mutual funds except UTI were to be
registered and governed. The erstwhile Kothari Pioneer (now merged with Franklin Templeton)
was the first private sector mutual fund registered in July 1993. The 1993 SEBI (Mutual Fund)
Regulations were substituted by a more comprehensive and revised Mutual Fund Regulations in
1996. The industry now functions under the SEBI (Mutual Fund) Regulations 1996. The number of
mutual fund houses went on increasing, with many foreign mutual funds setting up funds in India.
The industry has also witnessed several mergers and acquisitions. As at the end of January 2003,
there were 33 mutual funds with total assets of `1,21,805 crores. The Unit Trust of India with `
44,541 crores of assets under management was way ahead of other mutual funds.
Fourth Phase – since February 2003- April 2014
In February 2003, following the repeal of the Unit Trust of India Act 1963, UTI was bifurcated into
two separate entities. One is the Specified Undertaking of the Unit Trust of India (SUUTI) with
assets under management of ` 29,835 crores as at the end of January 2003, representing
broadly, the assets of US 64 scheme, assured return and certain other schemes. The Specified
Undertaking of Unit Trust of India, functioning under an administrator and u nder the rules framed
by Government of India does not come under the purview of the Mutual Fund Regulations. The
second is the UTI Mutual Fund, sponsored by SBI, PNB, BOB and LIC. It is registered with SEBI
and functions under the Mutual Fund Regulations. With the bifurcation of the erstwhile UTI which
had in March 2000 more than ` 76,000 crores of assets under management and with the setting
MUTUAL FUNDS 77.5
up of a UTI Mutual Fund, conforming to the SEBI Mutual Fund Regulations, and with recent
mergers taking place among different private sector funds, the mutual fund industry has entered its
current phase of consolidation and growth.
Moreover, in its effort to increase investor awareness, the industry and the Securities and
Exchange Board of India (SEBI) have launched several initiatives. These include literature and
campaigns to propagate financial education to various investor segment s (including potential
investors), such as school and college students, homemakers, executives, etc.
Mutual Fund Industry also could not be saved itself from the financial turmoil of 2009 as securities
market tanked. In addition to that the absolution of Entry Load by SEBI also worsen the situation
for MF industry who was already struggling to maintain its economic viability during 2010 -2013.
Fifth Phase – since May 2014
To ‘re-energies’ the Indian Mutual Fund industry and increase in its penetration, SEBI introduced
several measures. With formation of new Government and success measures taken in reversion of
negative trend, the situation improved significantly. Hence, since May 2014, the industry has
witnessed steady inflow and increase in number of investors as well as of AUM.
MF Distributors connected themselves to small towns and also enabled investors to invest in
appropriate schemes and retain investor in during the course of volatility and experiencing them
benefit of investing in Mutual Fund.
With ‘hand holding’ of investors and MF Distributors, who convinced them to stay invested and
encouraging them to invest in MF and when NAV in financial year 2015-16 witnessed steady
positive net inflow though same year was not good for Indian securities markets.
3. CLASSIFICATION OF MUTUAL FUNDS

There are three different types of classification of mutual funds - (1) Functional (2) Portfolio and (3)
Ownership.
3.1 Functional Classification
Funds are divided into:
(1) Open-Ended funds
(2) Close-Ended funds and
In an Open-Ended scheme, the investor can make entry and exit at any time. Also, the capital of
the fund is unlimited, and the redemption period is indefinite.
On the contrary, in a Close-Ended scheme, the investor can buy into the scheme during Initial
Public offering or from the stock market after the units have been list ed. The scheme has a limited
life at the end of which the corpus is liquidated. The investor can make his exit from the scheme by
selling in the stock market, or at the expiry of the scheme or during repurchase period at his
option.
Interval schemes are a cross between an Open-Ended and a Close-Ended structure. These
schemes are open for both purchase and redemption during pre-specified intervals (viz. monthly,
quarterly, annually etc.) at prevailing NAV based prices. Interval funds are very similar to Close-
Ended funds, but differ on the following points:
• They are not required to be listed on the stock exchanges, as they have an in-built redemption
window.
• They can make fresh issue of units during the specified interval period, at the prevailing NAV
based prices.
• Maturity period is not defined.
3.2 Portfolio Classification
Funds are classified into Equity Funds, Debt Funds and Special Funds.
Equity funds invest primarily in stocks. A share of stock represents a unit of ownership in a
company. If a company is successful, shareholders can profit in two ways:
• the stock may increase in value, or
• the company can pass its profits to shareholders in the form of dividends.
If a company fails, a shareholder can lose the entire value of his or her shares; however, a
shareholder is not liable for the debts of the company.
3.2.1 Equity Funds
Equity Funds are of the following types viz.
(a) Growth Funds: They seek to provide long term capital appreciation to the investor and are
best to long term investors.
(b) Aggressive Funds: They look for super normal returns for which investment is made in
start-ups, IPOs and speculative shares. They are best to investors willing to take risks.
(c) Income Funds: They seek to maximize present income of investors by investing in safe
stocks paying high cash dividends and in high yield money market instruments. They are
best to investors seeking current income.
3.2.2 Debt Funds
Debt Funds are of two types viz.
(a) Bond Funds: They invest in fixed income securities e.g. government bonds, corporate
debentures, convertible debentures, money market. Investors seeking tax free income go in
for government bonds while those looking for safe, steady income buy government bonds or
MUTUAL FUNDS 77.7
high grade corporate bonds. Although there have been past exceptions, bond funds tend to
be less volatile than stock funds and often produce regular income. For these reasons,
investors often use bond funds to diversify, provide a stream of income, or inves t for
intermediate-term goals. However, like stock funds, bond funds also have following risks and
can lose money.
❖ Interest Rate Risk: This risk relates to fluctuation in market value of Bond consequent
upon the change in interest rate (YTM) as discussed in the chapter on Security
Valuation. There is inverse relationship between market value of bond and interest
rate. As interest rate goes up market value of Bond falls and vice versa.
❖ Credit Risk: This risk is similar to risk of default in repayment of loans or payment of
interest or both by the borrowers of the funds. Thus, this risk takes place when a
Mutual Fund which invested money in the Bonds of a company defaulted in the
payment of Interest or Principal.
This risk is higher in case of companies with lower Credit Rating.
❖ Prepayment Risk: This risk is related to early refund of money by the issuer of Bonds
before the date of maturity. This generally happens in case of falling interest rates
when a company who already issued Bond at higher interest rate issues fresh Bonds
at lower rate of interest exercising its right of early redemption of Callable Bonds and
refunding the money raised out of fresh issue.
(b) Gilt Funds: They are mainly invested in Government securities.
3.2.3 Special Funds
Special Funds are of four types viz.
(a) Index Funds: Every stock market has a stock index which measures the upward and
downward sentiment of the stock market. Index Funds are low cost funds and influence the
stock market. The investor will receive whatever the market delivers.
(b) International Funds: A mutual fund located in India to raise money in India for investing
globally.
(c) Offshore Funds: A mutual fund located in India to raise money globally for investing in
India.
(d) Sector Funds: They invest their entire fund in a particular industry e.g. utility fund for utility
industry like power, gas, public works.
(e) Money Market Funds: These are predominantly debt-oriented schemes, whose main
objective is preservation of capital, easy liquidity and moderate income. To achieve this
objective, liquid funds invest predominantly in safer short-term instruments like Commercial
Papers, Certificate of Deposits, Treasury Bills, G-Secs etc.
These schemes are used mainly by institutions and individuals to park their surplus funds
for short periods of time. These funds are more or less insulated from changes in the
interest rate in the economy and capture the current yields prevailing in the market.
(f) Fund of Funds: Fund of Funds (FoF) as the name suggests are schemes which invest in
other mutual fund schemes. The concept is popular in markets where there are number of
mutual fund offerings and choosing a suitable scheme according to one’s objective is tough.
Just as a mutual fund scheme invests in a portfolio of securities such as equity, debt etc,
the underlying investments for a FoF is the units of other mutual fund schemes, either from
the same fund family or from other fund houses.
(g) Capital Protection Oriented Fund: The term ‘capital protection oriented scheme’ means a
mutual fund scheme which is designated as such and which endeavours to protect the
capital invested therein through suitable orientation of its portfolio structure. The orientation
towards protection of capital originates from the portfolio structure of the scheme and not
from any bank guarantee, insurance cover etc. SEBI stipulations require these types of
schemes to be close-ended in nature, listed on the stock exchange and the intended
portfolio structure would have to be mandatory rated by a credit rating agency. A typical
portfolio structure could be to set aside major portion of the assets for capital safety and
could be invested in highly rated debt instruments. The remaining portion would be invested
in equity or equity related instruments to provide capital appreciation. Capital P rotection
Oriented schemes are a recent entrant in the Indian capital markets and should not be
confused with ‘capital guaranteed’ schemes.
(h) Gold Funds: The objective of these funds is to track the performance of Gold. The units
represent the value of gold or gold related instruments held in the scheme. Gold Funds
which are generally in the form of an Exchange Traded Fund (ETF) are listed on the stock
exchange and offers investors an opportunity to participate in the bullion market without
having to take physical delivery of gold.
MUTUAL FUNDS 77.9
3.3 Ownership Classification

Funds are classified into Public Sector Mutual Funds, Private Sector Mutual Funds and Foreign
Mutual Funds. Public Sector Mutual Funds are sponsored by a company of the public sector. Private
Sector Mutual Fund is sponsored by a company of the private sector. Foreign Mutual Funds are
sponsored by companies for raising funds in India, operate from India and invest in India.
3.4 Direct Plans in Mutual Funds
Asset management companies (AMC) have been permitted to make direct investments in mutual
fund schemes even before 2011, but there were no separate plans for these investments. These
investments were made in distributor plan itself and were tracked with single NAV - one of the
distributor plans. Therefore, an investor was forced to buy mutual funds based on the NAV of the
distributor plans. However, things changed with introduction of direct plans by SEBI on
January 1, 2013.
Mutual fund direct plans are those plan where Asset Management Companies or mutual fund
Houses do not charge distributor expenses, trail fees and transaction charges. NAV of the direct
plan are generally higher in comparison to a regular plan. Studies have shown that the ‘Direct
Plans’ have performed better than the ‘Regular Plans’ for almost all the mutual fund schemes.
4. TYPES OF SCHEMES
4.1 Balanced Funds
Balanced funds make strategic allocation to both debt as well as equities. It mainly works on the
premise that while the debt portfolio of the scheme provides stability, the equity one provides
growth. It can be an ideal option for those who do not like total exposure to equity, but only
substantial exposure. Such funds provide moderate returns to the investors as the investors are
neither taking too high risk nor too low a risk.
4.2 Equity Diversified Funds
A Diversified funds is a fund that contains a wide array of stocks. The fund manager of a
diversified fund ensures a high level of diversification in its holdings, thereby reducing the amount
of risk in the fund.
a. Flexicap/ Multicap Fund: These are by definition, diversified funds. The only difference is
that unlike a normal diversified fund, the offer document of a multi-cap/flexi-cap fund generally
spells out the limits for minimum and maximum exposure to each of the market caps.
b. Contra fund: A contra fund invests in those out-of-favour companies that have
unrecognised value. It is ideally suited for investors who want to invest in a fund that has the
potential to perform in all types of market environments as it blends together both growth and
value opportunities. Investors who invest in contra funds have an aggressive risk appetite.
c. Index fund: An index fund seeks to track the performance of a benchmark market index
like the BSE Sensex or S&P CNX Nifty. Simply put, the fund maintains the portfolio of all the
securities in the same proportion as stated in the benchmark index and earns the same return as
earned by the market.
d. Dividend Yield fund: A dividend yield fund invests in shares of companies having high
dividend yields. Dividend yield is defined as dividend per share divided by the share’s market
price. Most of these funds invest in stocks of companies having a dividend yield higher than the
dividend yield of a particular index, i.e., Sensex or Nifty. The prices of dividend yielding stocks are
generally less volatile than growth stocks. Besides, they also offer the potential to appreciate.
Among diversified equity funds, dividend yield funds are considered to be a medium -risk
proposition. However, it is important to note that dividend yield funds have not alw ays proved
resilient in short-term corrective phases. Dividend yield schemes are of two types:
• Dividend Payout Option: Dividends are paid out to the unit holders under this option.
However, the NAV of the units falls to the extent of the dividend paid out and applicable
statutory levies.
• Dividend Re-investment Option: The dividend that accrues on units under option is re-
invested back into the scheme at ex-dividend NAV. Hence investors receive additional units
on their investments in lieu of dividends.
4.3 Equity Linked Savings Scheme (ELSS)
ELSS is one of the options for investors to save taxes under Section 80 C of the Income Tax Act.
They also offer the perfect way to participate in the growth of the capital market, having a lock -in-
period of three years. Besides, ELSS has the potential to give better returns than any traditional
tax savings instrument.
Moreover, by investing in an ELSS through a Systematic Investment Plan (SIP), one can not only
avoid the problem of investing a lump sum towards the end of the year but also take advantage of
“averaging”.
4.4 Sector Funds
These funds are highly focused on a particular industry. The basic objective is to enable investors
to take advantage of industry cycles. Since sector funds ride on market cycles, they have the
potential to offer good returns if the timing is perfect. However, they are bereft of downside risk
protection as available in diversified funds.
Sector funds should constitute only a limited portion of one’s portfolio, as they are much riskier
than a diversified fund. Besides, only those who have an existing portfolio should consider
investing in these funds.
For example, Real Estate Mutual Funds invest in real estate properties and earn income in the
form of rentals, capital appreciation from developed properties. Also some part of the fund corpus
MUTUAL FUNDS 77.11
is invested in equity shares or debentures of companies engaged in real estate assets or

developing real estate development projects. REMFs are required to be close -ended in nature and
listed on a stock exchange.
4.5 Thematic Funds
A Thematic fund focuses on trends that are likely to result in the ‘out -performance’ by certain
sectors or companies. The theme could vary from multi-sector, international exposure, commodity
exposure etc. Unlike a sector fund, theme funds have a broader outlook.
However, the downside is that the market may take a longer time to recognize views of the fund
house with regards to a particular theme, which forms the basis of launching a fund.
4.6 Arbitrage Funds
Typically, these funds promise safety of deposits, but better returns, tax benefits and greater
liquidity. Pru-ICICI is the latest to join the list with its equities and derivatives funds.
The open ended equity scheme aims to generate low volatility returns by inverting in a mix of cash
equities, equity derivatives and debt markets. The fund seeks to provide better returns than typical
debt instruments and lower volatility in comparison to equity.
This fund is aimed at an investor who seeks the return of small savings instru ments, safety of bank
deposits, tax benefits of RBI relief bonds and liquidity of a mutual fund.
Arbitrage fund finally seeks to capitalize on the price differentials between the spot and the futures
market.
The other schemes in the arbitrage universe are Benchmark Derivative, JM Equity and Derivatives,
Prudential ICICI Balanced, UTI Spread and Prudential ICICI Equity and Derivatives.
4.7 Hedge Fund
A Hedge Fund is a lightly regulated investment fund that escapes most regulations by being a sort
of a private investment vehicle being offered to selected clients.
The big difference between a hedge fund and a mutual fund is that the former does not reveal
anything about its operations publicly and charges a performance fee. Typically, if it outperforms a
benchmark, it takes a cut off the profits. Of course, this is a one way street; any losses are borne
by the investors themselves. Hedge funds are aggressively managed portfolio of investments
which use advanced investment strategies such as leveraged, long, short and derivative positions
in both domestic and international markets with the goal of generating high returns (either in an
absolute sense or over a specified market benchmark). It is important to note that hedging is
actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize
return on investment.
4.8 Cash Fund

Cash Fund is an open ended liquid scheme that aims to generate returns with lower volatility and
higher liquidity through a portfolio of debt and money market instrument.
The fund will have retail institutional and super institutional plans. Each plan will offer growth and
dividend options.
4.9 Exchange Traded Funds
An Exchange Traded Fund (ETF) is a hybrid product that combines the features of an index fund.
These funds are listed on the stock exchanges and their prices are linked to the underlying index.
The authorized participants act as market makers for ETFs.
ETFs can be bought and sold like any other stock on an exchange. In other words, ETFs can be
bought or sold any time during the market hours at prices that are expected to be closer to the
NAV at the end of the day. Therefore, one can invest at real time prices as against the end of the
day prices as is the case with open-ended schemes.
There is no paper work involved for investing in an ETF. These can be bought like any other stock
by just placing an order with a broker. ETFs may be attractive as investments because of their low
costs, tax efficiency, and stock-like features. An ETF combines the valuation feature of a mutual
fund or unit investment trust, which can be bought or sold at the end of each trading day for its net
asset value, with the tradability feature of a closed-end fund, which trades throughout the trading
day at prices that may be more or less than its net asset value. Following types of ETF products
are available in the market:
• Index ETFs - Most ETFs are index funds that hold securities and attempt to replicate the
performance of a stock market index.
• Commodity ETFs - Commodity ETFs invest in commodities, such as precious metals and
futures.
• Bond ETFs - Exchange-traded funds that invest in bonds are known as bond ETFs. They
thrive during economic recessions because investors pull their money out of the stock
market and into bonds (for example, government treasury bonds or those issues by
companies regarded as financially stable). Because of this cause and effect relationship,
the performance of bond ETFs may be indicative of broader economic conditions.
• Currency ETFs - The funds are total return products where the investor gets access to the
FX spot change, local institutional interest rates and a collateral yield.
4.10 Fixed Maturity Plans
Fixed Maturity Plans (FMPs) are closely ended mutual funds in which an investor ca n invest during
a New Fund Offer (NFO). FMPs usually invest in Certificates of Deposits (CDs), Commercial
Papers (CPs), Money Market Instruments and Non-Convertible Debentures over fixed investment
period. Sometimes, they also invest in Bank Fixed Deposits.
MUTUAL FUNDS 77.13
In New Fund Offers, during the course of which FMPs are issued, are later traded on the stock
exchange where they are listed. But, the trading in FMPs is very less. So, basically FMPs are not
liquid instruments.
The main advantage of Fixed Maturity Plans is that they are free from any interest rate risk because
FMPs invest in debt instruments that have the same maturity as that of the fund. However, they carry
credit risk, as there is a possibility of default by the debt issuing company. So, if the credit rating of an
instrument is downgraded, the returns of FMP can come down.
Presently, most of the FMPs are launched with tenure of three years to take the benefit of indexation.
But, because of the longer maturity period they find it difficult to provide good returns in the form of
interest to the investors in highest rated instruments. They, therefore assign some portions of the
invested funds in AA and below rated debt instruments to earn higher interest. The reason is that lower
rated instruments carry higher coupon rates than higher rated instruments.
5. ADVANTAGES OF MUTUAL FUND

(a) Professional Management: The funds are managed by skilled and professionally
experienced managers with a back up of a Research team.
(b) Diversification: Mutual Funds offer diversification in portfolio which reduces the risk.
(c) Convenient Administration: There are no administrative risks of share transfer, as many
of the Mutual Funds offer services in a demat form which save investor’s time and delay.
(d) Higher Returns: Over a medium to long-term investment, investors always get higher
returns in Mutual Funds as compared to other avenues of investment. This is already seen
from excellent returns, Mutual Funds have provided in the last few years. However,
investors are cautioned that such high returns riding on the IT boom should not be take n as
regular returns and therefore one should look at the average returns provided by the Mutual
Funds particularly in the equity schemes during the last couple of years.
(e) Low Cost of Management: No Mutual Fund can increase the cost beyond prescribed limits
of 2.5% maximum and any extra cost of management is to be borne by the AMC.
(f) Liquidity: In all the open ended funds, liquidity is provided by direct sales / repurchase by
the Mutual Fund and in case of close ended funds, the liquidity is provided b y listing the
units on the Stock Exchange.
(g) Transparency: The SEBI Regulations now compel all the Mutual Funds to disclose their
portfolios on a half-yearly basis. However, many Mutual Funds disclose this on a quarterly
or monthly basis to their investors. The NAVs are calculated on a daily basis in case of
open ended funds and are now published through AMFI in the newspapers.
(h) Other Benefits: Mutual Funds provide regular withdrawal and systematic investment plans
according to the need of the investors. The investors can also switch from one scheme to
another without any load.
(i) Highly Regulated: Mutual Funds all over the world are highly regulated and in India all
Mutual Funds are registered with SEBI and are strictly regulated as per the Mutual Fun d
Regulations which provide excellent investor protection.
(j) Economies of scale: The way mutual funds are structured gives it a natural advantage. The
“pooled” money from a number of investors ensures that mutual funds enjoy economies of scale;
it is cheaper compared to investing directly in the capital markets which involves higher charges.
This also allows retail investors access to high entry level markets like real estate, and also
there is a greater control over costs.
(k) Flexibility: There are a lot of features in a regular mutual fund scheme, which imparts
flexibility to the scheme. An investor can opt for Systematic Investment Plan (SIP),
Systematic Withdrawal Plan etc. to plan his cash flow requirements as per his convenience.
The wide range of schemes being launched in India by different mutual funds also provides
an added flexibility to the investor to plan his portfolio accordingly.
6. DRAWBACKS OF MUTUAL FUND

(a) No guarantee of Return – There are three issues involved:
(i) All Mutual Funds cannot be winners. There may be some who may underperform the
benchmark index i.e. it may not even perform well as a novice who invests in the
stocks constituting the index.
(ii) A mutual fund may perform better than the stock market but this does not necessarily
lead to a gain for the investor. The market may have risen and the mutual fund
scheme increased in value but the investor would have got the same increase had
he invested in risk free investments than in mutual fund.
(iii) Investors may forgive if the return is not adequate. But they will not do so if t he
principal is eroded. Mutual Fund investment may depreciate in value.
(b) Diversification – A mutual fund helps to create a diversified portfolio. Though diversification
minimizes risk, it does not ensure maximizing returns. The returns that mutual funds offer are
less than what an investor can achieve. For example, if a single security held by a mutual fund
doubles in value, the mutual fund itself would not double in value because that security is only
one small part of the fund's holdings. By holding a large number of different investments, mutual
funds tend to do neither exceptionally well nor exceptionally poor.
(c) Selection of Proper Fund – It may be easier to select the right share rather than the right
fund. For stocks, one can base his selection on the parameters of economic, industry and
company analysis. In case of mutual funds, past performance is the only criteria to fall back
upon but past cannot predict the future.
(d) Cost Factor – Mutual Funds carry a price tag. Fund Managers are the highest paid
executives. While investing, one has to pay for entry load and when leaving he has to pay
for exit load. Such costs reduce the return from mutual fund. The fees paid to the Asset
Management Company is in no way related to performance.
MUTUAL FUNDS 77.15
(e) Unethical Practices – Mutual Funds may not play a fair game. Each scheme may sell
some of the holdings to its sister concerns for substantive notional gains and posting NAVs
in a formalized manner.
(f) Taxes – When making decisions about your money, fund managers do not consider your
personal tax situations. For example when a fund manager sells a security, a capital gain
tax is triggered, which affects how profitable the individual is from sale. It might have been
more profitable for the individual to defer the capital gain liability.
(g) Transfer Difficulties – Complications arise with mutual funds when a managed portfolio is
switched to a different financial firm. Sometimes the mutual fund positions have to be
closed out before a transfer can happen. This can be a major problem for investors.
Liquidating a mutual fund portfolio may increase risk, increase fees and commissions, and
create capital gains taxes.
7. TERMS ASSOCIATED WITH MUTUAL FUNDS

7.1 Net Asset Value (NAV)
It is the amount which a unit holder would receive if the mutual fund were wound up. An investor in
mutual fund is a part owner of all its assets and liabilities. Returns to the investor are determined
by the interplay of two elements, Net Asset Value and Costs of Mutual Fund.Net Asset Value is the
mutual fund’s calling card. It is the basis for assessing the return that an investor has earned.
There are three aspects which need to be highlighted:
(i) It is the net value of all assets less liabilities. NAV represents the market value of total
assets of the Fund less total liabilities attributable to those assets.
(ii) NAV changes daily. The value of assets and liabilities changes daily. NAV today will not be
NAV tomorrow or day later.
(iii) NAV is computed on per unit basis i.e. dividing the Net Asset Value by number of
Outstanding Units.
How Net Asset Value is calculated?
It is value of net assets of the funds. The investor’s subscription is treated as the unit capital in the
balance sheet of the fund and the investments on their behalf are treated as assets. The fund’s net
assets are defined as the assets less liabilities.
Net asset of the scheme
NAV =
Number of units outs tanding
Net Assets of the Scheme = Market value of investments + Receivables + Other accrued income +
other assets - Accrued Expenses - Other Payables - Other Liabilities
7.2 Entry and Exit Load in Mutual Funds

Some Asset Management Companies (AMCs) have sales charges, or loads, on their funds (entry
load and/or exit load) to compensate for distribution costs. Funds that can be purchased without a
sales charge are called no-load funds.
Entry load is charged at the time an investor purchases the units of a scheme. The entry load
percentage is added to the prevailing NAV at the time of allotment of units.
Exit load is charged at the time of redeeming (or transferring an investment between schemes).
The exit load percentage is deducted from the NAV at the time of redemption (or transfer between
schemes). This amount goes to the Asset Management Company and not into the pool of funds of
the scheme. In simple terms, therefore, Entry and Exit Load in Mutual Fund are the charges one
pays while buying and selling the fund respectively .
Example
Mr. X earns 10% on his investments in equity shares. He is considering a recently floated scheme
of a Mutual Fund where the initial expenses are 6% and annual recurring expenses are expected
to be 2%. How much the Mutual Fund scheme should earn to provide a return of 10% to Mr. X?
Answer
1
r2 = x r1 + recurring exp.
1 − initial exp
1
The rate of return the mutual fund should earn;= x 0.1 + 0.02 = 0.1264 or 12.64%
1 − 0.06
7.3 Trail Commission
It is the amount that a mutual fund investor pays to his advisor each year. The purpose of charging
this commission from the investor is to provide incentive to the advisor to review their customer’s
holdings and to give advice from time to time.
Distributors usually charge a trail commission of 0.30-0.75% on the value of the investment for
each year that the investor's money remains invested with the fund company.
This is calculated on a daily basis as a percentage of the assets under management of the
distributor and is paid monthly. This is separate from any upfront commission that is usually paid
by the fund company to the distributor out of its own pocket.
7.4 Expense Ratio
It is the percentage of the assets that were spent to run a mutual fund. It includes things like
management and advisory fees, travel costs and consultancy fees. The expense ratio does not
include brokerage costs for trading the portfolio. It is also referred to as the Management Expense
Ratio (MER).
MUTUAL FUNDS 77.17
Paying close attention to the expense ratio is necessary. The reason is it can sometimes be as
high as 2-3% which can seriously undermine the performance of a mutual fund.
7.5 Side Pocketing
In simple words, a Side Pocketing in Mutual Funds leads to separation of risky assets from other
investments and cash holdings. The purpose is to make sure that money invested in a mutual
fund, which is linked to stressed assets, gets locked, until the fund recovers the money from the
company or could avoid distress selling of illiquid securities.
The modus operandi is simple. Whenever, the rating of a mutual fund decreases, the fund shifts
the illiquid assets into a side pocket so that current shareholders can be benefitted from the liquid
assets. Consequently, the Net Asset Value (NAV) of the fund will then reflect the actual value of
the liquid assets.
Side Pocketing is beneficial for those investors who wish to hold on to the units of the main funds
for long term. Therefore, the process of Side Pocketing ensures that liquidity is not the problem
even in the circumstances of frequent allotments and redemptions.
Side Pocketing is quite common internationally. However, Side Pocketing has also been resorted
to bereft the investors of genuine returns.
In India recent fiasco in the Infrastructure Leasing and Financial Services (IL&FS) has led to many
discussions on the concept of side pocketing as IL&FS and its subsidiaries have failed to fulfill its
repayments obligations due to severe liquidity crisis.
The Mutual Funds have given negative returns because they have completely written off their
exposure to IL&FS instruments.
7.6 Tracking Error
Tracking error can be defined as the divergence or deviation of a fund’s return from the
benchmarks return it is following.
The passive fund managers closely follow or track the benchmark index. Although they design
their investment strategy on the same index but often it may not exactly replicate the index return.
In such situation, there is possibility of deviation between the returns.
The tracking error can be calculated on the basis of corresponding benchmark return vis a vis
quarterly or monthly average NAVs.
Higher the tracking error higher is the risk profile of the fund. Whether the funds outperform or
underperform their benchmark indices; it clearly indicates that of fund managers are not following
the benchmark indices properly. In addition to the same other reason for track ing error are as
follows:
• Transaction cost
• Fees charged by AMCs

• Fund expenses
• Cash holdings
• Sampling biasness
Thus from above it can be said that to replicate the return to any benchmark index the tracking
error should be near to zero.
The Tracking Error is calculated as follows:
 (d - d )
2
TE =
n-1
d = Differential return
^d = Average differential return
n = No. of observation
TEST YOUR KNOWLEDGE

1. Explain how to establish a Mutual Fund.
2. What are the advantages of investing in Mutual Funds?
Practical Questions
1. Mr. A can earn a return of 16 per cent by investing in equity shares on his own. Now he is
considering a recently announced equity based mutual fund scheme in which init ial
expenses are 5.5 per cent and annual recurring expenses are 1.5 per cent. How much
should the mutual fund earn to provide Mr. A return of 16 per cent?
2. The unit price of Equity Linked Savings Scheme (ELSS) of a mutual fund is ` 10/-. The
public offer price (POP) of the unit is ` 10.204 and the redemption price is ` 9.80.
Calculate:
(i) Front-end Load
(ii) Back end Load
3. A mutual fund that had a net asset value of ` 20 at the beginning of month - made income and
capital gain distribution of ` 0.0375 and ` 0.03 per share respectively during the month, and
then ended the month with a net asset value of ` 20.06. Calculate monthly return.
MUTUAL FUNDS 77.19
4. An investor purchased 300 units of a Mutual Fund at ` 12.25 per unit on 31 st December,
2009. As on 31st December, 2010 he has received ` 1.25 as dividend and ` 1.00 as capital
gains distribution per unit.
Required :
(i) The return on the investment if the NAV as on 31 st December, 2010 is ` 13.00.
(ii) The return on the investment as on 31 st December, 2010 if all dividends and capital
gains distributions are reinvested into additional units of the fund at ` 12.50 per unit.
5. SBI mutual fund has a NAV of ` 8.50 at the beginning of the year. At the end of the year
NAV increases to ` 9.10. Meanwhile fund distributes ` 0.90 as dividend and ` 0.75 as
capital gains.
(i) What is the fund’s return during the year?
(ii) Had these distributions been re-invested at an average NAV of ` 8.75 assuming 200
units were purchased originally. What is the return?
6. The following information is extracted from Steady Mutual Fund’s Scheme:
- Asset Value at the beginning of the month - ` 65.78
- Annualised return -15 %
- Distributions made in the nature of Income - ` 0.50 and ` 0.32
& Capital gain (per unit respectively).
(i) Calculate the month end net asset value of the mutual fund scheme (limit your
answers to two decimals).
(ii) Provide a brief comment on the month end NAV.
7. Cinderella Mutual Fund has the following assets in Scheme Rudolf at the close of business
on 31 s t March,2014.
Company No. of Shares Market Price Per Share
Nairobi Ltd. 25000 ` 20
Dakar Ltd. 35000 ` 300
Senegal Ltd. 29000 ` 380
Cairo Ltd. 40000 ` 500
The total number of units of Scheme Rudol fare 10 lacs. The Scheme Rudolf has accrued
expenses of ` 2,50,000 and other liabilities of ` 2,00,000. Calculate the NAV per unit of the
Scheme Rudolf.
8. A Mutual Fund Co. has the following assets under it on the close of business as on:
1st February 2012 2nd February 2012
Company No. of Shares Market price per share Market price per share
` `
L Ltd 20,000 20.00 20.50
M Ltd 30,000 312.40 360.00
N Ltd 20,000 361.20 383.10
P Ltd 60,000 505.10 503.90
Total No. of Units 6,00,000

(i) Calculate Net Assets Value (NAV) of the Fund.
(ii) Following information is given:
Assuming one Mr. A, submits a cheque of ` 30,00,000 to the Mutual Fund and the
Fund manager of this company purchases 8,000 shares of M Ltd; and the balance
amount is held in Bank. In such a case, what would be the position of the Fund?
(iii) Find new NAV of the Fund as on 2nd February 2012.
9. On 1st April 2009 Fair Return Mutual Fund has the following assets and prices at 4.00 p.m.
Shares No. of Shares Market Price Per Share (`)
A Ltd. 10000 19.70
B Ltd. 50000 482.60
C Ltd. 10000 264.40
D Ltd. 100000 674.90
E Ltd. 30000 25.90
No. of units of funds 8,00,000
Please calculate:
(a) NAV of the Fund on 1 st April 2009.
(b) Assuming that on 1 st April 2009, Mr. X, a HNI, send a cheque of ` 50,00,000 to the
Fund and Fund Manager immediately purchases 18000 shares of C Ltd. and balance
is held in bank. Then what will be position of fund.
(c) Now suppose on 2 April 2009 at 4.00 p.m. the market price of shares is as follows:
Shares `
A Ltd. 20.30
MUTUAL FUNDS 77.21
B Ltd. 513.70
C Ltd. 290.80
D Ltd. 671.90
E Ltd. 44.20
Then what will be new NAV.
10. A has invested in three Mutual Fund Schemes as per details below:
Particulars MF A MF B MF C
Date of investment 01.12.2009 01.01.2010 01.03.2010
Amount of investment ` 50,000 ` 1,00,000 ` 50,000
Net Asset Value (NAV) at entry date ` 10.50 ` 10 ` 10
Dividend received upto 31.03.2010 ` 950 ` 1,500 Nil
NAV as at 31.03.2010 ` 10.40 ` 10.10 ` 9.80
Required:
What is the effective yield on per annum basis in respect of each of the three schemes to
Mr. A upto 31.03.2010?
11. Mr. Sinha has invested in three Mutual fund schemes as per details below:
Scheme X Scheme Y Scheme Z
Date of Investment 01.12.2008 01.01.2009 01.03.2009
Amount of Investment ` 5,00,000 ` 1,00,000 ` 50,000
Net Asset Value at entry date ` 10.50 ` 10.00 ` 10.00
Dividend received upto 31.03.2009 ` 9,500 ` 1,500 Nil
NAV as at 31.3.2009 ` 10.40 ` 10.10 ` 9.80
You are required to calculate the effective yield on per annum basis in respect of each of
the three schemes to Mr. Sinha upto 31.03.2009.
12. Mr. Y has invested in the three mutual funds (MF) as per the following details:
Particulars MF ‘X’ MF ‘Y’ MF ‘Z’
Amount of Investment (`) 2,00,000 4,00,000 2,00,000
Net Assets Value (NAV) at the time of purchase (`) 10.30 10.10 10
Dividend Received up to 31.03.2018 (`) 6,000 0 5,000
NAV as on 31.03.2018 (`) 10.25 10 10.20
Effective Yield per annum as on 31.03.2018 9.66 -11.66 24.15
(percent)
Assume 1 Year =365 days
Mr. Y has misplaced the documents of his investment. Help him in finding the date of his
original investment after ascertaining the following:
(i) Number of units in each scheme;
(ii) Total NAV;
(iii) Total Yield; and
(iv) Number of days investment held.
13. Mr. X on 1.7.2007, during the initial offer of some Mutual Fund invested in 10,000 units
having face value of ` 10 for each unit. On 31.3.2008, the dividend paid by the M.F. was
10% and Mr. X found that his annualized yield was 153.33%. On 31.12.2009, 20% dividend
was given. On 31.3.2010, Mr. X redeemed all his balance of 11,296.11 units when his
annualized yield was 73.52%. What are the NAVs as on 31.3.2008, 31.3.2009 and
31.3.2010?
14. Mr. X on 1.7.2012, during the initial public offer of a Mutual Fund (MF) invested
` 1,00,000 at Face Value of ` 10. On 31.3.2013, the MF declared a dividend of 10% when
Mr. X calculated that his holding period return was 115%. On 31.3.2014, MF again declared
a dividend of 20%. On 31.3.2015, Mr. X redeemed all his investment which had
accumulated to 11,296.11 units when his holding period return was 202.17%.
Calculate the NAVs as on 31.03.2013, 31.03.2014 and 31.03.2015.
15. A Mutual Fund having 300 units has shown its NAV of ` 8.75 and ` 9.45 at the beginning
and at the end of the year respectively. The Mutual Fund has given two options:
(i) Pay ` 0.75 per unit as dividend and ` 0.60 per unit as a capital gain, or
(ii) These distributions are to be reinvested at an average NAV of ` 8.65 per unit.
What difference it would make in terms of return available and which option is preferable?
16. On 1-4-2012 ABC Mutual Fund issued 20 lakh units at ` 10 per unit. Relevant initial
expenses involved were ` 12 lakhs. It invested the fund so raised in capital market
instruments to build a portfolio of ` 185 lakhs. During the month of April 2012 it disposed
off some of the instruments costing ` 60 lakhs for ` 63 lakhs and used the proceeds in
purchasing securities for ` 56 lakhs. Fund management expenses for the month of April
2012 was ` 8 lakhs of which 10% was in arrears. In April 2012 the fund earned dividends
amounting to ` 2 lakhs and it distributed 80% of the realized earnings. On 30-4-2012 the
market value of the portfolio was ` 198 lakhs.
Mr. Akash, an investor, subscribed to 100 units on 1-4-2012 and disposed off the same at
closing NAV on 30-4-2012. What was his annual rate of earning?
17. Sun Moon Mutual Fund (Approved Mutual Fund) sponsored open-ended equity oriented
scheme “Chanakya Opportunity Fund”. There were three plans viz. ‘A’ – Dividend Re-
investment Plan, ‘B’ – Bonus Plan & ‘C’ – Growth Plan.
At the time of Initial Public Offer on 1.4.1999, Mr. Anand, Mr. Bacchan & Mrs. Charu, three
investors invested ` 1,00,000 each & chosen ‘B’, ‘C’ & ‘A’ Plan respectively.
MUTUAL FUNDS 77.23
The History of the Fund is as follows:

Date Dividend % Bonus Ratio Net Asset Value per Unit (F.V. ` 10)
Plan A Plan B Plan C
28.07.2003 20 30.70 31.40 33.42
31.03.2004 70 5:4 58.42 31.05 70.05
31.10.2007 40 42.18 25.02 56.15
15.03.2008 25 46.45 29.10 64.28
31.03.2008 1:3 42.18 20.05 60.12
24.03.2009 40 1:4 48.10 19.95 72.40
31.07.2009 53.75 22.98 82.07
On 31st July all three investors redeemed all the balance units.
Calculate annual rate of return to each of the investors.
Consider:
1. Long-term Capital Gain is exempt from Income tax.
2. Short-term Capital Gain is subject to 10% Income tax.
3. Security Transaction Tax 0.2 per cent only on sale/redemption of units.
4. Ignore Education Cess.
18. A mutual fund company introduces two schemes i.e. Dividend plan (Plan-D) and Bonus plan
(Plan-B). The face value of the unit is ` 10. On 1-4-2005 Mr. K invested ` 2,00,000 each in
Plan-D and Plan-B when the NAV was ` 38.20 and ` 35.60 respectively. Both the plans
matured on 31-3-2010.
Particulars of dividend and bonus declared over the period are as follows:
Date Dividend Bonus Net Asset Value (`)
% Ratio Plan D Plan B
30-09-2005 10 39.10 35.60
30-06-2006 1:5 41.15 36.25
31-03-2007 15 44.20 33.10
15-09-2008 13 45.05 37.25
30-10-2008 1:8 42.70 38.30
27-03-2009 16 44.80 39.10
11-04-2009 1:10 40.25 38.90
31-03-2010 40.40 39.70
What is the effective yield per annum in respect of the above two plans?
19. A mutual fund made an issue of 10,00,000 units of ` 10 each on January 01, 2008. No
entry load was charged. It made the following investments:
Particulars `
50,000 Equity shares of ` 100 each @ ` 160 80,00,000
7% Government Securities 8,00,000
9% Debentures (Unlisted) 5,00,000
10% Debentures (Listed) 5,00,000
98,00,000
During the year, dividends of ` 12,00,000 were received on equity shares. Interest on all
types of debt securities was received as and when due. At the end of the year equity shares
and 10% debentures are quoted at 175% and 90% respectively. Other investme nts are at
par.
Find out the Net Asset Value (NAV) per unit given that operating expenses paid during the
year amounted to ` 5,00,000. Also find out the NAV, if the Mutual fund had distributed a
dividend of ` 0.80 per unit during the year to the unit holders.
20. Based on the following information, determine the NAV of a regular income scheme on per
unit basis:
Particulars ` Crores
Listed shares at Cost (ex-dividend) 20
Cash in hand 1.23
Bonds and debentures at cost 4.3
Of these, bonds not listed and quoted 1
Other fixed interest securities at cost 4.5
Dividend accrued 0.8
Amount payable on shares 6.32
Expenditure accrued 0.75
Number of units (` 10 face value) 20 lacs
Current realizable value of fixed income securities of face value of 106.5
` 100
The listed shares were purchased when Index was 1,000
Present index is 2,300
Value of listed bonds and debentures at NAV date 8
There has been a diminution of 20% in unlisted bonds and debentures. Other fixed interest
securities are at cost.
MUTUAL FUNDS 77.25
21. On 1st April, an open ended scheme of mutual fund had 300 lakh units outstanding with Net
Assets Value (NAV) of ` 18.75. At the end of April, it issued 6 lakh units at opening NAV
plus 2% load, adjusted for dividend equalization. At the end of May, 3 Lakh units were
repurchased at opening NAV less 2% exit load adjusted for dividend equalization. At the
end of June, 70% of its available income was distributed.
In respect of April-June quarter, the following additional information are available:
` in lakh
Portfolio value appreciation 425.47
Income of April 22.950
Income for May 34.425
Income for June 45.450
You are required to calculate
(i) Income available for distribution;
(ii) Issue price at the end of April;
(iii) repurchase price at the end of May; and
(iv) net asset value (NAV) as on 30 th June.
22. Five portfolios experienced the following results during a 7- year period:
Average Annual Standard Correlation with the
Portfolio
Return (Rp) (%) Deviation (Sp) market returns (r)
A 19.0 2.5 0.840
B 15.0 2.0 0.540
C 15.0 0.8 0.975
D 17.5 2.0 0.750
E 17.1 1.8 0.600
Market Risk (σm) 1.2
Market rate of Return (Rm) 14.0
Risk-free Rate (Rf) 9.0
Rank the portfolios using (a) Sharpe’s method, (b) Treynor’s method and (c) Jensen’s Alpha
23. There are two Mutual Funds viz. D Mutual Fund Ltd. and K Mutual Fund Ltd. Each having
close ended equity schemes.
NAV as on 31-12-2014 of equity schemes of D Mutual Fund Ltd. is ` 70.71 (consisting 99%
equity and remaining cash balance) and that of K Mutual Fund Ltd. is 62.50 (consisting 96%
equity and balance in cash).
Following is the other information:
Equity Schemes
Particular
D Mutual Fund Ltd. K Mutual Fund Ltd.
Sharpe Ratio 2 3.3
Treynor Ratio 15 15
Standard deviation 11.25 5
There is no change in portfolios during the next month and annual average cost is ` 3 per
unit for the schemes of both the Mutual Funds.
If Share Market goes down by 5% within a month, calculate expected NAV after a month for
the schemes of both the Mutual Funds.
For calculation, consider 12 months in a year and ignore number of days for particular
month.
24. ANP Plan, a hedge fund currently has assets of ` 20 crore. CA. X, the manager of fund
charges fee of 0.10% of portfolio asset. In addition to it he charges incentive fee of 2%. The
incentive will be linked to gross return each year in excess of the portfolio maximum value
since the inception of fund. The maximum value the fund achieved so far since inception of
fund about one and half year ago was ` 21 crores.
You are required to compute the fee payable to CA. X, if return on the fund this year turns out to be
(a) 29%, (b) 4.5%, (c) -1.8%
25. Ms. Sunidhi is working with an MNC at Mumbai. She is well versant with the portfolio
management techniques and wants to test one of the techniques on an equity fund she has
constructed and compare the gains and losses from the technique with those from a
passive buy and hold strategy. The fund consists of equities only and the ending NAVs of
the fund he constructed for the last 10 months are given below:
Month Ending NAV (`/unit) Month Ending NAV (`/unit)
December 2008 40.00 May 2009 37.00
January 2009 25.00 June 2009 42.00
February 2009 36.00 July 2009 43.00
March 2009 32.00 August 2009 50.00
April 2009 38.00 September 2009 52.00
Assume Sunidhi had invested a notional amount of ` 2 lakhs equally in the equity fund and
a conservative portfolio (of bonds) in the beginning of December 2008 and the total portfolio
was being rebalanced each time the NAV of the fund increased or decreased by 15%.
You are required to determine the value of the portfolio for each level of NAV following the
Constant Ratio Plan.
MUTUAL FUNDS 77.27

1. Establishment of a Mutual Fund: A mutual fund is required to be registered with the
Securities and Exchange Board of India (SEBI) before it can collect funds from the public.
All mutual funds are governed by the same set of regulations and are subject to monitoring
and inspections by the SEBI. The Mutual Fund has to be established through the medium of
a sponsor. A sponsor means any body corporate who, acting alone or in combination with
another body corporate, establishes a mutual fund after completing the formalities
prescribed in the SEBI's Mutual Fund Regulations.
The role of sponsor is akin to that of a promoter of a company, who provides the initial
capital and appoints the trustees. The sponsor should be a body corporate in the business
of financial services for a period not less than 5 years, be financially sound and be a fit
party to act as sponsor in the eyes of SEBI.
The Mutual Fund has to be established as either a trustee company or a Trust, under the
Indian Trust Act and the instrument of trust shall be in the form of a deed. The deed shall be
executed by the sponsor in favour of the trustees named in the instrument of trust. The trust
deed shall be duly registered under the provisions of the Indian Registration Act, 1908. The
trust deed shall contain clauses specified in the Third Schedule of the Regulations.
An Asset Management Company, who holds an approval from SEBI, is to be appointed to
manage the affairs of the Mutual Fund and it should operate the schemes of such fund. The
Asset Management Company is set up as a limited liability company, with a minimum net
worth of ` 10 crores.
The sponsor should contribute at least 40% to the networth of the Asset Management
Company. The Trustee should hold the property of the Mutual Fund in trust for the benefit of
the unit holders.
SEBI regulations require that at least two-thirds of the directors of the Trustee Company or
board of trustees must be independent, that is, they should not be associated with the
sponsors. Also, 50 per cent of the directors of AMC must be independent. The appointment
of the AMC can be terminated by majority of the trustees or by 75% of the unit holders of
the concerned scheme.
The AMC may charge the mutual fund with Investment Management and Advisory fees
subject to prescribed ceiling. Additionally, the AMC may get the expenses on operation of
the mutual fund reimbursed from the concerned scheme.
The Mutual fund also appoints a custodian, holding valid certificate of registration issued by
SEBI, to have custody of securities held by the mutual fund under different schemes. In
case of dematerialized securities, this is done by Depository Participant. The custodian
must be independent of the sponsor and the AMC.

1. Personal earnings of Mr. A = R 1 = 16%
Mutual Fund earnings = R 2
1
R2 = R 1 + Recurring expenses (% )
1 − Initial expenses (% )
1
=  16% + 1.5%
1 − 0.055
= 18.43%
Mutual Fund earnings = 18.43%
2. Public Offer Price = NAV/ (1 – Front end Load)
Public Offer Price: ` 10.204 and NAV: ` 10
Accordingly,
10.204 = 10/(1 – F)
F = 0.0199 say 2%
Redemption Price = NAV/ (1 – Back End Load)
` 9.80 = 10/ (1 – Back End Load)
B = 0.0204 i.e. 2.04%
MUTUAL FUNDS 77.29
Alternative
10.204 − 10.00
(i) Front End Load = = 0.0204 or 2.04%
10.00
10.00 − 9.80
(ii) Exit Load = = 0.020 or 2.00%
10.00
3. Calculation of Monthly Return on the Mutual Funds
 (NAV - NAV ) + I + G 
r =  t t- 1 t t

 NAV 
t- 1
Where,
r = Return on the mutual fund
NAVt = Net assets value at time period t
NAVt – 1 = Net assets value at time period t – 1
It = Income at time period t
Gt = Capital gain distribution at time period t
 ( ` 20.06 − ` 20.00 ) + ( ` 0.0375 + ` 0.03 ) 
r =  
 20 
0.06 + 0.0675
=
20
0.1275
= = 0.006375
20
Or, r = 0.6375% p.m.
Or = 7.65% p.a.
4. Return for the year (all changes on a per year basis)
Particulars ` /Unit
Change in price (` 13.00 – ` 12.25) 0.75
Dividend received 1.25
Capital gain distribution 1.00
Total Return 3.00
3.00
Return on investment =  100 = 24.49%
12.25

(NAV1 - NAV0 )+ D1 + CG1
X100
NAV0
(13 -12.25) + 1.25 + 1.00

= X 100
12.25
= 24.49%
If all dividends and capital gain are reinvested into additional units at ` 12.50 per unit the
position would be.
Total amount reinvested = ` 2.25  300 = ` 675
` 675
Additional units added = = 54 units
12.50
Value of 354 units as on 31-12-2010 = ` 4,602
Price paid for 300 units on 31-12-2009 (300  ` 12.25) = ` 3,675
` 4,602 - ` 3,675 ` 927
Return = = = 25.22%
` 3,675 ` 3,675
5. (i) Normal Return for the year (all changes on a per year basis)
Particulars ` /Unit
Change in price (` 9.10 – ` 8.50) 0.60
Dividend received 0.90
Capital gain distribution 0.75
Total Return 2.25
2.25
Return on investment =  100 = 26.47%
8.50
(ii) If all dividends and capital gain are reinvested into additional units at ` 8.75 per unit
the position would be.
Total amount reinvested = ` 1.65  200 = ` 330
` 330
Additional units added = = 37.71 units
8.75
Value of 237.71 units at end of year = ` 2,163.16
Price paid for 200 units in beginning of the year (200  ` 8.50) = ` 1,700
MUTUAL FUNDS 77.31
` 2,163.16 - ` 1,700 ` 463.16

Return = = = 27.24%
` 1,700 ` 1,700
6. (i) Calculation of NAV at the end of month:

Given Annual Return = 15%
Hence Monthly Return = 1.25% (r)
(NAV t - NAVt -1 ) + It +G t
r=
NAVt -1
0.0125 =
(NAVt − ` 65.78) + ` 0.50 + ` 0.32
` 65.78
0.82 = NAVt - ` 64.96
NAVt = ` 65.78
(ii) There is no change in NAV.
7.
Shares No. of shares Price Amount (`)

Nairobi Ltd. 25,000 20.00 5,00,000
Dakar Ltd. 35,000 300.00 1,05,00,000
Senegal Ltd. 29,000 380.00 1,10,20,000
Cairo Ltd. 40,000 500.00 2,00,00,000
4,20,20,000
Less: Accrued Expenses 2,50,000
Other Liabilities 2,00,000
Total Value 4,15,70,000
No. of Units 10,00,000
NAV per Unit (4,15,70,000/10,00,000) 41.57
8. (i) NAV of the Fund

` 4,00,000 + ` 93,72,000 + ` 72,24,000 + ` 3,03,06,000
=
6,00,000
` 4,73,02,000
= = ` 78.8366 rounded to ` 78.84
6,00,000
(ii) The revised position of fund shall be as follows:

L Ltd. 20,000 20.00 4,00,000
M Ltd. 38,000 312.40 1,18,71,200
N Ltd. 20,000 361.20 72,24,000
P Ltd. 60,000 505.10 3,03,06,000
Cash 5,00,800
5,03,02,000
30,00,000
No. of units of fund = 6,00,000 + = 6,38,053
78.8366
(iii) On 2nd February 2012, the NAV of fund will be as follows:
L Ltd. 20,000 20.50 4,10,000
M Ltd. 38,000 360.00 1,36,80,000
N Ltd. 20,000 383.10 76,62,000
P Ltd. 60,000 503.90 3,02,34,000
Cash 5,00,800
5,24,86,800
` 5,24,86,800
NAV as on 2nd February 2012 = = ` 82.26 per unit
6,38,053
9. (a) NAV of the Fund.
` 1,97,000 +` 2,41,30,000 +` 26,44,000 +` 6,74,90,000 +` 7,77,000
=
800000
` 9,52,38,000
= = ` 119.0475 rounded to ` 119.05
800000
(b) The revised position of fund shall be as follows:
Shares No. of shares Price Amount (Rs.)
A Ltd. 10000 19.70 1,97,000
B Ltd. 50000 482.60 2,41,30,000
C Ltd. 28000 264.40 74,03,200
D Ltd. 100000 674.90 674,90,000
E Ltd. 30000 25.90 7,77,000
Cash 2,40,800
10,02,38,000
MUTUAL FUNDS 77.33
5000000
No. of units of fund = 800000 + = 842000
119.0475
(c) On 2nd April 2009, the NAV of fund will be as follows:
A Ltd. 10000 20.30 2,03,000
B Ltd. 50000 513.70 2,56,85,000
C Ltd. 28000 290.80 81,42,400
D Ltd. 100000 671.90 6,71,90,000
E Ltd. 30000 44.20 13,26,000
Cash 2,40,800
10,27,87,200
` 10,27,87,200
NAV as on 2nd April 2009 = = ` 122.075 per unit
842000
10.
Scheme Investment Unit Nos. Unit NAV Total NAV 31.3.2010

(Investment/NAV at entry 31.3.2010 (Unit Nos. X Unit
date) NAV as on
31.3.2010)
` ` `
MF A 50,000 4761.905 10.40 49,523.812
MF B 1,00,000 10,000 10.10 1,01,000
MF C 50,000 5,000 9.80 49,000
Scheme NAV Dividend Total Yield Number Effective Yield

(+) / (–) Received Change in of days (% P.A.) (Total
NAV Yield/
(NAV as on 31.3.2010
+Dividend Investment) X
–Investment)
(365/No. of
days)
X 100
` ` `
MF A (–)476.188 950 473.812 121 2.858%
MF B (+)1,000 1,500 2,500 90 10.139%
MF C (–)1,000 Nil (–)1,000 31 (–)24%
11. Calculation of effective yield on per annum basis in respect of three mutual fund schemes to
Mr. Sinha up to 31-03-2009:
Particulars MF X MF Y MF Z
(a) Investments ` 5,00,000 ` 1,00,000 ` 50,000
(b) Opening NAV `10.50 `10.00 `10.00
(c) No. of units (a/b) 47,619.05 10,000 5,000
(d) Unit NAV ON 31-3-2009 ` 10.40 ` 10.10 ` 9.80
(e) Total NAV on 31-3-2009 (c x d) ` 4,95,238.12 ` 1,01,000 ` 49,000
(f) Increase / Decrease of NAV (e - a) (` 4,761.88) ` 1,000 (` 1,000)
(g) Dividend Received ` 9,500 ` 1,500 Nil
(h) Total yield (f + g) ` 4,738.12 ` 2,500 (` 1,000)
(i) Number of Days 121 90 31
(j) Effective yield p.a. (h/a x 365/i x 2.859% 10.139% (-) 23.55%
100)
12. (i) Number of Units in each Scheme

MF ‘X’ ` 2,00,000
= 19,417.48
` 10.30
MF ‘Y’ ` 4,00,000
= 39,603.96
` 10.10
MF ‘Z’ ` 2,00,000
= 20,000.00
` 10.00
(ii) Total NAV on 31.03.2018

MF ‘X’ = 19,417.48 x ` 10.25 ` 1,99,029.17
MF ‘Y’ = 39,603.96 x ` 10.00 ` 3,96,039.60
MF ‘Z’ = 20,000.00 x ` 10.20 ` 2,04,000.00
Total ` 7,99,068.77
MUTUAL FUNDS 77.35
(iii) Total Yield

Capital Yield Dividend Yield Total
MF ‘X’ ` 1,99,029.17- ` 2,00,000 ` 6,000 ` 5,029.17
= - ` 970.83
MF ‘Y’ ` 3,96,039.60 - ` Nil - ` 3,960.40
4,00,000
= - ` 3,960.40
MF ‘Z’ ` 2,04,000 - ` 2,00,000 ` 5,000 ` 9,000.00
= ` 4,000
Total ` 10,068.77
` 10,068.77
Total Yield =  100 = 1.2586%
` 8,00,000
(iv) No. of Days Investment Held

MF ‘X’ MF ‘Y’ MF ‘Z’
Let No. of days be X Y Z
Initial Investment (`) 2,00,000 4,00,000 2,00,000
Yield (`) 5,029.17 -3,960.40 9,000.00
Yield (%) 2.5146 - 0.9901 4.5
Period of Holding (Days) 2.5146 − 0.9901 4.5
 365  365  365
9.66 − 11.66 24.15
= 95 Days = 31 Days = 68 Days
Date of Original Investment 26.12.17 28.02.18 22.01.18
13. Yield for 9 months = (153.33 x 9/12) = 115%
Market value of Investments as on 31.03.2008 = 1,00,000/- + (1,00,000x 115%)
= `2,15,000/-
Therefore, NAV as on 31.03.2008 = (2,15,000-10,000)/10,000= `20.50
(NAV would stand reduced to the extent of dividend payout, being (10,000x10x10%) = `10,000)
`10,000
Since dividend was reinvested by Mr. X, additional units acquired = = 487.80 units
` 20.50
Therefore, units as on 31.03.2008 = 10, 000+ 487.80 = 10,487.80
[Alternately, units as on 31.03.2008 = (2,15,000/20.50) = 10,487.80]
Dividend as on 31.03.2009 = 10,487.80 x 10 x 0.2 = `20,975.60
Let X be the NAV on 31.03.2009, then number of new units reinvested will be `
20,975.60/X. Accordingly 11296.11 units shall consist of reinvested units and 10487.80 (as
on 31.03.2008). Thus, by way of equation it can be shown as follows:
20975.60
11296.11 = + 10487.80
X
Therefore, NAV as on 31.03.2009 = 20,975.60/(11,296.11- 10,487.80)
= `25.95
NAV as on 31.03.2010 = ` 1,00,000 (1+0.7352x33/12)/11296.11
= ` 26.75
14. Yield for 9 months = 115%
Market value of Investments as on 31.03.2013 = 1,00,000/- + (1,00,000x 115%)
= ` 2,15,000/-
Therefore, NAV as on 31.03.2013 = (2,15,000 -10,000)/10,000 = ` 20.50
(NAV would stand reduced to the extent of dividend payout, being (`100,000 x 10%)
= ` 10,000)
Since dividend was reinvested by Mr. X, additional units acquired
` 10,000
= = 487.80 units
` 20.50
Therefore, units as on 31.03.2013 = 10,000+ 487.80 = 10,487.80
[Alternately, units as on 31.03.2013 = (2,15,000/20.50) = 10,487.80]
Dividend as on 31.03.2014 = 10,487.80 x 10 x 0.2 = ` 20,975.60
Let X be the NAV on 31.03.2014, then number of new units reinvested will be
` 20,975.60/X. Accordingly 11296.11 units shall consist of reinvested units and 10487.80
(as on 31.03.2013). Thus, by way of equation it can be shown as follows:
20975.60
11296.11 = + 10487.80
X
Therefore, NAV as on 31.03.2014 = 20,975.60/(11,296.11- 10,487.80)
= ` 25.95
NAV as on 31.03.2015 = ` 1,00,000 (1+2.0217)/11296.11
= ` 26.75
MUTUAL FUNDS 77.37
15. (i) Returns for the year

(All changes on a Per -Unit Basis)
Change in Price: ` 9.45 – `8.75 = ` 0.70
Dividends received: ` 0.75
Capital gains distribution ` 0.60
Total reward ` 2.05
` 2.05
Holding period reward:  100 = 23.43%
` 8.75
(ii) When all dividends and capital gains distributions are re-invested into additional
units of the fund @ (` 8.65/unit)
Dividend + Capital Gains per unit
= ` 0.75 + ` 0.60 = ` 1.35
Total received from 300 units = `1.35 x 300 = `405/-.
Additional Units Acquired
= `405/`8.65 = 46.82 Units.
Total No.of Units = 300 units + 46.82 units = 346.82 units.
Value of 346.82 units held at the end of the year
= 346.82 units x `9.45 = `3277.45
Price Paid for 300 Units at the beginning of the year
= 300 units x `8.75 = `2,625.00
Holding Period Reward
` (3277.45 – 2625.00) = `652.45
` 652.45
Holding Period Reward =  100 = 24.85%
` 2625.00
Conclusion: Since the holding period reward is more in terms of percentage in
option-two i.e., reinvestment of distributions at an average NAV of `8.65 per unit,
this option is preferable.
16.
Amount in Amount in Amount in

` lakhs ` lakhs ` lakhs
Opening Bank (200 - 185 -12) 3.00
Add: Proceeds from sale of securities 63.00
Add: Dividend received 2.00 68.00
Deduct:
Cost of securities purchased 56.00
Fund management expenses paid (90% of 7.20
8)
Capital gains distributed = 80% of (63 – 2.40
60)
Dividend distributed =80% of 2.00 1.60 67.20
Closing Bank 0.80
Closing market value of portfolio 198.00
198.80
Less: Arrears of expenses 0.80
Closing Net Assets 198.00
Number of units (Lakhs) 20
Closing NAV per unit (198.00/20) 9.90
Rate of Earning (Per Unit)

Amount
Income received (` 2.40 + ` 1.60)/20 ` 0.20
Loss: Loss on disposal (` 200 - ` 198)/20 ` 0.10
Net earning ` 0.10
Initial investment ` 10.00
Rate of earning (monthly) 1%
Rate of earning (Annual) 12%
MUTUAL FUNDS 77.39
17. Mrs. Charu Plan A Dividend Reinvestment

(Amount in ` )
Date Investment Dividend Dividend Re- NAV Units Closing
payout invested (Closing Unit
(%) Units X Face value Balance
of ‘10 X Dividend ∑ Units
Payout %)
01.04.1999 1,00,000.00 10.00 10,000.00 10,000.00
28.07.2003 20 20,000.00 30.70 651.47 10,651.47
31.03.2004 70 74,560.29 58.42 1,276.28 11,927.75
30.10.2007 40 47,711.00 42.18 1,131.13 13,058.88
15.03.2008 25 32,647.20 46.45 702.85 13,761.73
24.03.2009 40 55,046.92 48.10 1,144.43 14,906.16
Redemption value 14,906.16  53.75 8,01,206.10
Less: Security Transaction Tax (STT) is 0.2% 1,602.41
Net amount received 7,99,603.69
Less: Short term capital gain tax @ 10% on 1,144.43 (53.64* – 48.10≈) = 634
6,340
Net of tax 7,98,969.69
Less: Investment 1,00,000.00
6,98,969.69
*(53.75 – STT @ 0.2%)
≈ This value can also be taken as zero
6,98,969.69 12
Annual average return (%)   100 = 67.64 %
1,00,000 124
Mr. Anand Plan B – Bonus

(Amount in `)
Date Units Bonus units Total Balance NAV per unit
01.04.1999 10,000 10,000 10
31.03.2004 12,500 22,500 31.05
31.03.2008 7,500 30,000 20.05
24.03.2009 7,500 37,500 19.95
Redemption value 37,500  22.98 8,61,750.00

Less: Security Transaction Tax (STT) is 0.2% 1,723.50
Less: Short term capital gain tax @ 10%
7,500  (22.93† – 19.95) = 22,350 2,235.00
Net of tax 8,57,791.50
Net gain 7,57,791.50
†(22.98 – STT @ 0.2%)
7,57,791.50 12
1,00,000 124
Mr. Bacchan Plan C – Growth

Particulars (Amount in `)
Redemption value 10,000  82.07 8,20,700.00
Less: Security Transaction Tax (S.T.T) is .2% 1,641.40
Less: Short term capital gain tax @ 10% 0.00
Net of tax 8,19,058.60
Net gain 7,19,058.60
7,19,058 12
1,00,000 124
Note: Alternatively, figure of * and † can be taken as without net of Tax because, as per
Proviso 5 of Section 48 of IT Act, no deduction of STT shall be allowed in computation of
Capital Gain.
18. Plan – D
2,00,000
Unit acquired = = 5235.60
38.20
Date Units held Dividend Reinvestment New Total
% Amount Rate Units Units
01.04.2005 5235.60
30.09.2005 5235.60 10 5235.60 39.10 133.90 5369.50
MUTUAL FUNDS 77.41
31.03.2007 5369.50 15 8054.25 44.20 182.22 5551.72

15.09.2008 5551.72 13 7217.24 45.05 160.20 5711.92
27.03.2009 5711.92 16 9139.07 44.80 204 5915.92
31.03.2010 Maturity Value (` 40.40 X 5915.92) ` 2,39,003.17
Less: Cost of Acquisition ` 2,00,000.00
Total Gain ` 39,003.17
` 39,003.17 1
Effective Yield =   100 = 3.90%
` 2,00,000 5
Alternatively, it can be computed by using the IRR method as follows:

NPV at 4% = -2,00,000 + 1,96,443 = -3,557
NPV at 2% = -2,00,000 + 2,16,473 = 16,473
NPV at LR 16473
IRR= LR + (HR -LR) = 2% + ( 4% - 2% ) = 3.645%
NPV at LR -NPV at HR 16473 - (-3557)
Plan – B
Date Particulars Calculation Working No. of Units NAV (`)
1.4.05 Investment `2,00,000/35.60= 5617.98 35.60
30.6.06 Bonus 5617.98/5 = 1123.60 36.25
6741.58
30.10.08 " 6741.58/8 = 842.70 38.30
7584.28
11.4.09 " 7584.28/10 = 758.43 38.90
8342.71
31.3.10 Maturity Value 8342.71 x ` 39.70= 3,31,205.59
Gain 1,31,205.59
1,31,205.59 1
Effective Yield x x100 = 13.12%
2,00,000 5
Alternatively, it can be computed by using the IRR method as follows:
NPV at 13% = -2,00,000 + 1,79,765 = -20,235
NPV at 8% = -2,00,000 + 2,25,413 = 25,413
NPV at LR 25413
IRR= LR + (HR - LR) = 8% + (13% − 8%) = 10.78%
NPV at LR - NPV at HR 25413 − ( −20235)
19. In order to find out the NAV, the cash balance at the end of the year is calculat ed as
follows-
Particulars `
Cash balance in the beginning
(` 100 lakhs – ` 98 lakhs) 2,00,000
Dividend Received 12,00,000
Interest on 7% Govt. Securities 56,000
Interest on 9% Debentures 45,000
Interest on 10% Debentures 50,000
15,51,000
(-) Operating expenses 5,00,000
Net cash balance at the end 10,51,000
Calculation of NAV `
Cash Balance 10,51,000
7% Govt. Securities (at par) 8,00,000
50,000 equity shares @ ` 175 each 87,50,000
9% Debentures (Unlisted) at cost 5,00,000
10% Debentures @90% 4,50,000
Total Assets 1,15,51000
NAV per Unit ` 11.55
Calculation of NAV, if dividend of ` 0.80 is paid –

Net Assets (` 1,15,51,000 – ` 8,00,000) ` 1,07,51,000
NAV per unit ` 10.75
20.
Particulars Adjusted Values
` crores
Equity Shares 46.00
Cash in hand 1.23
Bonds and debentures not listed 0.80
MUTUAL FUNDS 77.43
Bonds and debentures listed 8.00

Dividends accrued 0.80
Fixed income securities 4.50
Sub total assets (A) 61.33
Less: Liabilities
Amount payable on shares 6.32
Expenditure accrued 0.75
Sub total liabilities (B) 7.07
Net Assets Value (A) – (B) 54.26
No. of units 20,00,000
Net Assets Value per unit (` 54.26 crore / 20,00,000) ` 271.30
21. Calculation of Income available for Distribution
Units Per Unit Total
(Lakh) (`) (` In lakh)
Income from April 300 0.0765 22.9500
Add: Dividend equalization collected on issue 6 0.0765 0.4590
306 0.0765 23.4090
Add: Income from May 0.1125 34.4250
306 0.1890 57.8340
Less: Dividend equalization paid on repurchase 3 0.1890 (0.5670)
303 0.1890 57.2670
Add: Income from June 0.1500 45.4500
303 0.3390 102.7170
Less: Dividend Paid 0.2373 (71.9019)
303 0.1017 30.8151
Calculation of Issue Price at the end of April
`
Opening NAV 18.750
Add: Entry Load 2% of ` 18.750 (0.375)
19.125
Add: Dividend Equalization paid on Issue Price 0.0765
19.2015
Calculation of Repurchase Price at the end of May

`
Opening NAV 18.750
Less: Exit Load 2% of ` 18.750 (0.375)
18.375
Add: Dividend Equalization paid on Issue Price 0.1890
18.564
Closing NAV
` (Lakh)
Opening Net Asset Value (` 18.75 × 300) 5625.0000
Portfolio Value Appreciation 425.4700
Issue of Fresh Units (6 × 19.2015) 115.2090
Income Received (22.950 + 34.425 + 45.450) 102.8250
6268.504
Less: Units repurchased (3 × 18.564) -55.692
Income Distributed -71.9019 (-127.5939)
Closing Net Asset Value 6140.9101
Closing Units (300 + 6 – 3) lakh 303 lakh
 Closing NAV as on 30 th June ` 20.2670
22. Let portfolio standard deviation be σ p

Market Standard Deviation = σ m
Coefficient of correlation = r
σ pr
Portfolio beta (β p) =
σm
Required portfolio return (R p) = Rf + βp (Rm – Rf)

Portfolio Beta Return from the portfolio (Rp) (%)
A 1.75 17.75
B 0.90 13.50
C 0.65 12.25
D 1.25 15.25
E 0.90 13.50
MUTUAL FUNDS 77.45
Portfolio Sharpe Method Treynor Method Jensen's Alpha

Ratio Rank Ratio Rank Ratio Rank
A 4.00 IV 5.71 V 1.25 V
B 3.00 V 6.67 IV 1.50 IV
C 7.50 I 9.23 I 2.75 II
D 4.25 III 6.80 III 2.25 III
E 4.50 II 9.00 II 3.60 I
23. Working Notes:

(i) Decomposition of Funds in Equity and Cash Components
NAV on 31.12.14 ` 70.71 ` 62.50
% of Equity 99% 96%
Equity element in NAV ` 70 ` 60
Cash element in NAV ` 0.71 ` 2.50
(ii) Calculation of Beta
(a) D Mutual Fund Ltd.
E(R) - R f E(R) - R f
Sharpe Ratio = 2 = =
σD 11.25
E(R) - Rf = 22.50
E(R) - R f 22.50
Treynor Ratio = 15 = =
βD βD
βD = 22.50/15 = 1.50
(b) K Mutual Fund Ltd.
E(R) - R f E(R) - R f
Sharpe Ratio = 3.3 = =
σK 5
E(R) - Rf = 16.50
E(R) - R f 16.50
Treynor Ratio = 15 = =
βK βK
βK = 16.50/15 = 1.10
(iii) Decrease in the Value of Equity

Market goes down by 5.00% 5.00%
Beta 1.50 1.10
Equity component goes down 7.50% 5.50%
(iv) Balance of Cash after 1 month
Cash in Hand on 31.12.14 ` 0.71 ` 2.50
Less: Exp. Per month ` 0.25 ` 0.25
Balance after 1 month ` 0.46 ` 2.25
NAV after 1 month

Value of Equity after 1 month
70 x (1 - 0.075) ` 64.75 -
60 x (1 - 0.055) - ` 56.70
Cash Balance 0.46 2.25
65.21 58.95
24. (a) If return is 29%
`
Fixed fee (A) 0.10% of ` 20 crore 2,00,000
New Fund Value (1.29 x ` 20 crore) 25.80 crore
Excess Value of best achieved (25.8 crore – 21.0 crore) 4.80 crore
Incentive Fee (2% of 4.80 crores) (B) 9,60,000
Total Fee (A)+(B) 11,60,000
(b) If return is 4.5%

`
Fixed (A) 0.10% of ` 20 crore 2,00,000
New Fund Value (1.045 x ` 20 crore) 20.90 crore
Excess Value of best achieved (20.90 crore –21.00 crore) (` 0.10 crore)
Incentive Fee (as does not exceed best achieved) (B) Nil
Total Fee (A)+(B) 2,00,000
MUTUAL FUNDS 77.47
(c) If return is (-1.8%)

No incentive only fixed fee of ` 2,00,000 will be paid
25. Constant Ratio Plan:
Stock Value of Value of Total value Revaluation Total No.
Portfolio Conservative aggressive of Constant Action of units in
NAV Portfolio Portfolio Ratio Plan aggressive
(`) (`) (`) (`) portfolio
40.00 1,00,000 1,00,000 2,00,000 - 2500
25.00 1,00,000 62,500 1,62,500 - 2500
81,250 81,250 1,62,500 Buy 750 units 3250
36.00 81,250 1,17,000 1,98,250 - 3250
99,125 99,125 1,98,250 Sell 496.53 units 2753.47
32.00 99,125 88,111.04 1,87,236.04 - 2753.47
38.00 99,125 1,04,631.86 2,03,756.86 - 2753.47
1,01,878.43 1,01,878.43 2,03,756.86 Sell 72.46 units 2681.01
37.00 1,01,878.50 99,197.37 2,01,075.87 - 2681.01
42.00 1,01,878.50 1,12,602.42 2,14,480.92 - 2681.01
43.00 1,01,878.50 1,15,283.43 2,17,161.93 - 2681.01
50.00 1,01,878.50 1,34,050.50 2,35,929 - 2681.01
1,17,964.50 1,17,964.50 2,35,929 Sell 321.72 units 2359.29
52.00 1,17,964.50 1,22,683.08 2,40,647.58 - 2359.29
Hence, the ending value of the mechanical strategy is ` 2,40,647.58 and buy & hold strategy is
` 2,60,000.
8
DERIVATIVES ANALYSIS
AND VALUATION
LEARNING OUTCOMES
❑ Forward/ Future Contract
❑ Options
❑ Swaps
❑ Commodity Derivatives
❑ Embedded Derivatives
1. INTRODUCTION
Derivative is a product whose value is to be derived from the value of one or more basic variables
called bases (underlying assets, index or reference rate). The underlying assets can be Equity,
Forex, and Commodity.
The underlying has a marketable value which is subject to market risks. The importance of
underlying in derivative instruments is as follows:
❖ All derivative instruments are dependent on an underlying to have value.
❖ The change in value in a forward contract is broadly equal to the change in value in the
underlying.
❖ In the absence of a valuable underlying asset the derivative instrument will have no value.
❖ On maturity, the position of profit/loss is determined by the price of underlying instruments.
If the price of the underlying is higher than the contract price the buyer makes a profit. If the
price is lower, the buyer suffers a loss.
Main users of Derivatives are as follows:

Users Purpose
(a) Corporation To hedge currency risk and inventory risk.
(b) Individual Investors For speculation, hedging and yield enhancement.
(c) Institutional Investor For hedging asset allocation, yield enhancement and to
avail arbitrage opportunities.
(d) Dealers For hedging position taking, exploiting inefficiencies and
earning dealer spreads.
The basic differences between Cash and the Derivative market are enumerated below:-
(a) In cash market tangible assets are traded whereas in derivative market contracts based on
tangible or intangibles assets like index or rates are traded.
(b) In cash market, we can purchase even one share whereas in Futures and Options minimum
lots are fixed.
(c) Cash market is more risky than Futures and Options segment because in “Futures and
Options” risk is limited upto 20%.
(d) Cash assets may be meant for consumption or investment. Derivative contracts are for
hedging, arbitrage or speculation.
(e) The value of derivative contract is always based on and linked to the underlying security.
However, this linkage may not be on point-to-point basis.
(f) In the cash market, a customer must open securities trading account with a securities
depository whereas to trade futures a customer must open a future trading account with a
derivative broker.
(g) Buying securities in cash market involves putting up all the money upfront whereas buying
futures simply involves putting up the margin money.
(h) With the purchase of shares of the company in cash market, the holder becomes part owner
of the company. While in future it does not happen.
The most important derivatives are forward, futures and options. Here we will discuss derivatives
as financial derivatives and embedded derivatives.
2. FORWARD CONTRACT
Consider a Punjab farmer who grows wheat and has to sell it at a profit. The simplest and the
traditional way for him is to harvest the crop in March or April and sell in the spot market then.
However, in this way the farmer is exposing himself to risk of a downward movement in the price of
wheat which may occur by the time the crop is ready for sale.
DERIVATIVES ANALYSIS AND VALUATION 78.3
In order to avoid this risk, one way could be that the farmer may sell his crop at an agreed-upon
rate now with a promise to deliver the asset, i.e., crop at a pre-determined date in future. This will
at least ensure to the farmer the input cost and a reasonable profit.
Thus, the farmer would sell wheat forward to secure himself against a possible loss in future. It is
true that by this way he is also foreclosing upon him the possibility of a bumper profit in the event
of wheat prices going up steeply but then more important is that the farmer has played safe and
insured himself against any eventuality of closing down his source of livelihood altogether. The
transaction which the farmer has entered into is called a forward transaction and the contract
which covers such a transaction is called a forward contract.
A forward contract is an agreement between a buyer and a seller obligating the seller to deliver a
specified asset of specified quality and quantity to the buyer on a specified date at a specified
place and the buyer, in turn, is obligated to pay to the seller a pre-negotiated price in exchange of
the delivery.
This means that in a forward contract, the contracting parties negotiate on, not only the price at
which the commodity is to be delivered on a future date but also on what quality and quantity to be
delivered and at what place. No part of the contract is standardised and the two parties sit across
and work out each and every detail of the contract before signing it.
For example, in case a gold bullion forward contract is being negotiated between two parties, they
would negotiate each of the following features of the contract:
❖ the weight of the gold bullion to be delivered,
❖ the fineness of the metal to be delivered,
❖ the place at which the delivery is to be made,
❖ the period after which the delivery is to be made, and
❖ the price which the buyer would pay.
Suppose a buyer L and a seller S agrees to do a trade in 100 tolas of gold on 31 Dec 20 13 at `
30,000/tola. Here, ` 30,000/tola is the ‘forward price of 31 Dec 2013 Gold’. The buyer L is said to
be in long position and the seller S is said to be in short position. Once the contract has been
entered into, L is obligated to pay S ` 30 lakhs on 31 Dec 2013, and take delivery of 100 tolas of
gold. Similarly, S is obligated to be ready to accept ` 30 lakhs on 31 Dec 2013, and give 100 tolas
of gold in exchange.
3. FUTURE CONTRACT
A Future Contract is an agreement between two parties that commits one party to buy an
underlying financial instrument (bond, stock or currency) or commodity (gold, soy abean or natural
gas) and one party to sell a financial instrument or commodity at a specific price at a future date.
The agreement is completed at a specified expiration date by physical delivery or cash settlement
or offset prior to the expiration date. In order to initiate a trade in futures contracts, the buyer and
seller must put up "good faith money" in a margin account. Regulators, commodity exchanges and
brokers doing business on commodity exchanges determine margin levels.
Suppose A buyer “B” and a Seller “S” enter into a 5,000 kgs Corn Futures contract at ` 5 per kg.
Assuming that on the second day of trading the settlement price is ` 5.20 per kg. Settlement price
is generally the representative price at which the contracts trade during the closing minutes of the
trading period and this price is designated by a stock exchange as the settlement price. In case
the price movement during the day is such that the price during the closing minutes is not the
representative price, the stock exchange may select a price which it feels is close to being a
representative price, e.g., average of the high and low prices which have occurred during a trading
day. This price movement has led to a loss of ` 1,000 to S while B has gained the corresponding
amount.
Thus, the initial margin account of S gets reduced by ` 1,000 and that of B is increased by the
same amount. While the margin accounts, also called the equity of the buyer and the seller, get
adjusted at the end of the day in keeping with the price movement, the futur es contract gets
replaced with a new one at a price which has been used to make adjustments to the buyer and
seller’s equity accounts. In this case, the settle price is ` 5.20, which is the new price at which
next day’s trading would start for this particular futures contract. Thus, each future contract is
rolled over to the next day at a new price. This is called marking-to-market.
Difference between forward and future contract is as follows:
S. No. Features Forward Futures

1. Trading Forward contracts are traded Futures Contracts are traded in a
on personal basis or on competitive arena.
telephone or otherwise.
2. Size of Forward contracts are Futures contracts are
Contract individually tailored and have standardized in terms of quantity
no standardized size or amount as the case may be
3. Organized Forward contracts are traded in Futures contracts are traded on
exchanges an over the counter market. organized exchanges with a
designated physical location.
4. Settlement Forward contracts settlement Futures contracts settlements are
takes place on the date agreed made daily via. Exchange’s
upon between the parties. clearing house.
5. Delivery Forward contracts may be Futures contracts delivery dates
date delivered on the dates agreed are fixed on cyclical basis and
upon and in terms of actual hardly takes place. However, it
delivery. does not mean that there is no

actual delivery.
6. Transaction Cost of forward contracts is Futures contracts entail
costs based on bid – ask spread. brokerage fees for buy and sell
order.
7. Marking to Forward contracts are not Futures contracts are subject to
market subject to marking to market marking to market in which the
loss or profit is debited or
credited in the margin account on
daily basis due to change in
price.
8. Margins Margins are not required in In futures contracts every
forward contract. participants is subject to maintain
margin as decided by the
exchange authorities
9. Credit risk In forward contract, credit risk In futures contracts the
is born by each party and, transaction is a two way
therefore, every party has to transaction, hence the parties
bother for the creditworthiness. need not to bother for the risk.
4. PRICING/ VALUATION OF FORWARD/ FUTURE

CONTRACTS
The difference between the prevailing spot price of an asset and the futures price is known as the
Basis, i.e.,
Basis = Spot price – Futures price
In a normal market, the spot price is less than the futures price (which includes the full cost -of-
carry) and accordingly the basis would be negative. Such a market, in which the basis is decided
solely by the cost-of-carry is known as a contango market.
Basis can become positive, i.e., the spot price can exceed the futures price only if there are factors
other than the cost of carry to influence the futures price. In case this happens, then basis
becomes positive and the market under such circumstances is termed as a backwardation market
or inverted market.
Basis will approach zero towards the expiry of the contract, i.e., the spot and future s prices
converge as the date of expiry of the contract approaches. The process of the basis approaching
zero is called convergence.
The relationship between futures prices and cash prices is determined by the cost -of-carry.
However, there might be factors other than cost-of-carry, especially in stock futures in which there
may be various other returns like dividends, in addition to carrying costs, which may influence this
relationship.
The cost-of-carry model in for futures/ forward, is as under:-
Future price = Spot price + Carrying cost – Returns (dividends, etc).
Let us take an example to understand this relationship.
Example
The price of ACC stock on 31 December 2010 was ` 220 and the futures price on the same stock
on the same date, i.e., 31 December 2010 for March 2011 was ` 230. Other features of the
contract and related information are as follows:
Time to expiration - 3 months (0.25 year)
Borrowing rate - 15% p.a.
Annual Dividend on the stock - 25% payable before 31.03. 2011
Face Value of the Stock - ` 10
Based on the above information, the futures price for ACC stock on 31 December 2010 should be:
= 220 + (220 x 0.15 x 0.25) – (0.25 x 10) = 225.75
Thus, as per the ‘cost of carry’ criteria, the futures price is ` 225.75, which is less than the actual
price of ` 230 on 31 March 2011. This would give rise to arbitrage opportunities and consequently
the two prices will tend to converge.
How Will the Arbitrager Act?
He will buy the ACC stock at ` 220 by borrowing the amount @ 15 % for a period of 3 months and
at the same time sell the March 2011 futures on ACC stock. By 31st March 2011, he will receive
the dividend of ` 2.50 per share. On the expiry date of 31st March, he will deliver the ACC stock
against the March futures contract sales.
The arbitrager’s inflows/outflows are as follows:
Sale proceeds of March 2011 futures ` 230.00
Dividend ` 2.50
Total (A) ` 232.50
Pays back the Bank ` 220.00
Cost of borrowing ` 8.25
Total (B) ` 228.25
Balance (A) – (B) ` 4.25
Thus, the arbitrager earns ` 4.25 per share without involving any risk.
In financial forward contracts, the cost of carry is primarily the interest cost.
Let us take a very simple example of a fixed deposit in the bank. ` 100 deposited in the bank at a
rate of interest of 10% would be come ` 110 after one year. Based on annual compounding, the
amount will become ` 121 after two years. Thus, we can say that the forward price of the fixed
deposit of ` 100 is ` 110 after one year and ` 121 after two years.
As against the usual annual, semi-annual and quarterly compounding, which the reader is normally
used to, continuous compounding are used in derivative securities. In terms of the annual
compounding, the forward price can be computed through the following formul a:
A = P (1+r/100)t
Where, A is the terminal value of an amount P invested at a rate of interest of r % p.a. for t years.
However, in case there are multiple compounding in a year, say n times per annum, then the
above formula will read as follows:
A = P (1+r/n)nt
And in case the compounding becomes continuous, i.e., more than daily compounding, the above
formula can be simplified mathematically and rewritten as follows:
A = Pert
Where
e = Called epsilon, is a mathematical constant and has a value of 2.72.
r = Risk-free Rate of Interest
t = Time Period
This function is available in all mathematical calculators and is easy to handle.
The above formula gives the future value of an amount invested in a particular security now. In
this formula, we have assumed no interim income flow like dividends etc
Example
Consider a 3-month maturity forward contract on a non-dividend paying stock. The stock is
available for ` 200. With compounded continuously risk-free rate of interest (CCRRI) of 10 % per
annum, the price of the forward contract would be:
A = 200 x e(0.25)(0.10) = ` 205.06
In case there is cash income accruing to the security like dividends, the above formula will read as
follows:
A = (P-I)ert
Where I is the present value of the income flow during the tenure of the contract.
Example
Consider a 4-month forward contract on 500 shares with each share priced at ` 75. Dividend @ `
2.50 per share is expected to accrue to the shares in a period of 3 months. The CCRRI is 10%
p.a. The value of the forward contract is as follows:
Dividend proceeds = 500 × 2.50 = 1250
= 1250e- (3/12)(0.10) = 1219.13
Value of forward contract = (500 × 75 – 1219.13) e (4/12)(0.10)
= 36280.87 x e 0.033
= ` 37498.11
However, in case the income accretion to the securities is in the form of percentage yield, y, as in
the case of stock indices arising on account of dividend accruals to individual stocks constituting
the index, the above formula will read as follows:
A = Pe n(r – y)
Correlation between Forward and Futures Prices
For contracts of the same maturity, the forward and futures contracts tend to have the same value
subject to the interest rates remaining fixed. In case the interest rates are fluid, the value of a
futures contract would differ from that of a forward contract because the cash flows generated from
marking to the market in the case of the former would be available for reinvestment at variable
rates on a day-to-day basis. However, market imperfections like transaction costs, taxes and
asset indivisibilities bring futures prices close enough to the forward prices to safely assume the
two prices to be practically the same.
5. TYPES OF FUTURES CONTRACTS

5.1 Single Stock Futures
A single stock futures contract is an agreement to buy or sell shares or stock s uch as Microsoft,
Intel, ITC, or Tata Steel at a point in the future. The buyer has an obligation to purchase shares or
stock and the seller has an obligation to sell shares or stock at a specific price at a specific date in
the future. Thus a stock futures contract is a standardized contract to buy or sell a specific stock at
a future date at an agreed price. Single-stock futures contracts are completed via offset or the
delivery of actual shares at expiration. Margin on a single-stock futures contract is expected
normally to be 20% of notional value.
Each Stock Future contract is standardized and includes basic specifications.
The terms of the contract call for delivery of the stock by the seller at some time specified in the
future. However, most contracts are not held to expiration. The contracts are standardized, making
them highly liquid. To get out of an open long (buying) position, the investor simply takes an
offsetting short position (sells). Conversely, if an investor has sold (short) a contract and wishes to
close it out, he or she buys (goes long) the offsetting contract.
5.2 Index Futures
A contract for stock index futures is based on the level of a particular stock index such as the S&P
500 or the Dow Jones Industrial Average or NIFTY or BSE Sensex. The agreement calls for the
contract to be bought or sold at a designated time in the future. Just as hedgers and speculators
buy and sell futures contracts based on future prices of individual stocks they may—for mostly the
same reasons—buy and sell such contracts based on the level of a number of stock indexes.
Stock index futures may be used to either speculate on the equity market's general performance or
to hedge a stock portfolio against a decline in value. Unlike commodity futures or individual stocks,
stock index futures are not based on tangible goods, thus all settlements are in cash. Because
settlements are in cash, investors usually have to meet liquidity or income requirements to show
that they have money to cover their potential losses.
Stock index futures are traded in terms of number of contracts. Each contract is to buy or sell a
fixed value of the index. The value of the index is defined as the value of the index multiplied by
the specified monetary amount. In Nifty 50 futures contract traded at the National Stock Exchange,
the contract specification states:
1 Contract = 50 units of Nifty 50 * Value of Nifty 50
If we assume that Nifty 50 is quoting at 8000 , the value of one contract will be equal to ` 4,00,000
(50*8000 ). The contract size of 50 units of Nifty 50 in this case is fixed by National Stock
Exchange where the contract is traded.
Example
Consider the following:
Current value of index - ` 1400
Dividend yield - 6%
CCRRI - 10%
To find the value of a 3 month forward contract.
A = Pe t(r – y)
= ` 1400 x e (3/12)(0.10 – .06) = ` 1400 x 1.01005 = ` 1,414.07
5.2.1 Trading Mechanism in Stock Futures
While trading in futures contracts (both stock as well as futures) both buyers and sellers of the
contract have to deposit an initial margin with their brokers based on the value of contact entered.
The rules for calculation of margins to be deposited with the brokers are framed by the stock
exchanges.
Another major feature regarding the margin requirements for stock as wel l index futures is that the
margin requirement is continuous. Every business day, the broker will calculate the margin
requirement for each position. The investor will be required to post additional margin funds if the
account does not meet the minimum margin requirement.
The investor can square off his position in the futures contract before expiry or wait till expiry date
when the contracts will automatically stand as squared off at the closing price on the expiry date.
In Indian stock market the expiry date is the last Thursday of the relevant month to which the
future contract belongs.
Example–Margin Requirements
In a stock future contract on ITC stock at ` 120, both the buyer and seller have a margin
requirement of 20% or ` 24. If ITC stock goes up to ` 122, the account of the long contract is
credited with ` 200 (` 122-` 120 = ` 2 X 100 = ` 200) and the account of the seller (seller) is
debited by the same ` 200. This indicates that investors in futures must be very vigilant - they
must keep close track of market movements.
5.2.2 Purpose of Trading in Futures
Trading in futures is for two purposes namely:
(a) Speculation and
(b) Hedging
(a) Speculation – For simplicity we will assume that one contract= 100 units and the margin
requirement is 20% of the value of contract entered. Brokerage and transaction costs are not taken
into account.
Example- Going Long on a Single Stock Futures Contract
Suppose an investor is bullish on McDonald's (MCD) and goes long on one September stock
future contract on MCD at ` 80. At some point in the near future, MCD is trading at ` 96. At that
point, the investor sells the contract at ` 96 to offset the open long position and makes a ` 1600
gross profit on the position.
This example seems simple, but let’s examine the trades closely. The investor's initial margin
requirement was only ` 1600 (` 80 x 100 = ` 8,000 x 20% = ` 1600). This investor had a 100%
return on the margin deposit. This dramatically illustrates the leverage power of trading futures. Of
course, had the market moved in the opposite direction, the investor easily could have
experienced losses in excess of the margin deposit.
The pay off table for the above transaction can be depicted as follows: -
Particulars Details Inflow/(outflow){In `}
Initial Payoff - Margin ` 8000 x 20% = ` 1600 (` 1600)
(Refundable at maturity)
Pay off upon squaring off the Profit (` 96 - ` 80) x 100 = ` 3200
contract ` 1600
Initial Margin = ` 1600
Net Payoff ` 1600
Example- Going Short on a Single Stock Futures Contract
An investor is bearish in Kochi Refinery (KR) stock for the near future and goes short an August
stock future contract on KR at ` 160. KR stock performs as the investor had guessed and drops to
` 140 in July. The investor offsets the short position by buying an August stock future at ` 140.
This represents a gross profit of ` 20 per share, or a total of ` 2,000.
Again, let's examine the return the investor had on the initial deposit. The initial margin requirement
was ` 3,200 (` 160 x 100 = ` 16,000 x 20% = ` 3,200) and the gross profit was ` 2,000. The return on
the investor's deposit was more than 60% - a terrific return on a short-term investment.
Initial Payoff - Margin (Refundable ` 160 x 100 x 20% = ` 3200 (` 3200)
at maturity)
Pay off upon squaring off the Profit (` 160 - ` 140) x 100 = ` 5200
contract ` 2000 Initial Margin = `
3200
Net Payoff ` 2000
Example- Going Long on an Index Futures Contract

Suppose an investor has a bullish outlook for Indian market for the month of October 2014. He will
go for a long position one October 2014 Nifty Index Future Contract. Assuming that he enters into
long positions when Nifty is trading at 8000 and one month later he squares off his position when
the value of Nifty rises to 8500 his payoff will be as under. (Assuming that one contract= 50 units
of Nifty and margin requirement is 20% of the value of the contract)
Initial Payoff - Margin (8000 x 50 x 20%) = ` 80,000 (` 80,000)
Pay off upon squaring off Profit (8500 - 8000) x 50 = ` 25,000 ` 1,05,000
the contract Initial Margin = ` 80,000
Net Payoff ` 25,000
Example- Going Short on an Index Futures Contract

Suppose an investor has a bearish outlook for Indian banking sector for the month of October
2014. He will go for a short position for one October 2014 Bank Nifty Future Contract. Assuming
that he enters into short positions when Bank Nifty is trading at 25000 and one month later he
squares off his position when the value of Bank Nifty declines to 24000 his payoff will be as under.
(Assuming that one contract = 10 units of Bank Nifty and margin requirement is 20% of the value
of the contract)
Initial Payoff – Margin (25000 x 10 x 20%) = ` 50,000 (` 50,000)
Pay off upon squaring off Profit (25000-24000) x 10 = ` ` 60,000
the contract 10,000
Initial Margin = ` 50,000
Net Payoff ` 10,000
(b) Hedging – Hedging is the practice of taking a position in one market to offset and balance
against the risk adopted by assuming a position in a contrary or opposing market or investment. In
simple language, hedging is used to reduce any substantial losses/gains suffered by an i ndividual
or an organization. To hedge, the investor takes a stock future position exactly opposite to the
stock position. That way, any losses on the stock position will be offset by gains on the future
position.
Example- Using single stock future as a Hedge
Consider an investor who has bought 100 shares of Tata Steel (TS) at ` 300. In July, the stock is
trading at ` 350. The investor is happy with the unrealized gain of ` 50 per share but is concerned
that in a stock as volatile as TS, the gain could be wiped out in one bad day. The investor wishes
to keep the stock at least until September, however, because of an upcoming dividend payment.
To hedge, the investor sells a ` 350 September stock future contract - whether the stock rises or
declines, the investor has locked in the ` 50-per-share gain.In September on maturity date of the
futures contract (last Thursday of September) , the investor sells the stock at the market price and
buys back the future contract.
The pay-off at various price levels of Tata Steel is as under:-
Particulars September Closing September Closing September Closing

price of Tata price of Tata Steel= price of Tata Steel=
Steel= ` 300 ` 350 ` 400
Initial Payoff ` 300 x 100 = ` 300 x 100 = ` 300 x 100 =
` 30000 ` 30000 ` 30000
Cost of scrip in cash ` 350 x 100 x 20% ` 350 x 100 x 20% ` 350 x 100X20% =
market = `7000 = `7000 `7000

Margin Payment on ` 37000 ` 37000 ` 37000
futures contract
Total Initial Payoff
(outflow)
Pay-off at maturity Sale proceeds of Sale proceeds of TS Sale proceeds of TS
(September end) TS in cash in cash market= in cash market=
market= `300x `350x 100 = ` `400x 100 = `
100 = ` 30000 35000 40000
Margin refund on Margin refund on Margin refund on
futures contract = futures contract = futures contract =
` 7000 ` 7000 ` 7000
Gain on futures No profit /loss on Loss on futures
contract(inflow) = futures contract = contract(outflow) =
Total Pay-off at (` 350 - ` 300) x (` 350 - ` 350) x100 (` 350 -` 400) x 100
maturity (Inflow) 100 = ` 5000 =`0 = - ` 5000
` 42000 ` 42000 ` 42000
Net Payoff ` 5000 ` 5000 ` 5000
Hence it can be observed in the above table that in any case the investor has locked in a profit of
` 5000 via hedging.
In a similar manner as illustrated above index futures can also be used as a hedge. The difference
would be that instead of single stock futures the investor would enter into a position into a n Index
Futures Contract according to the risk potential of the investor. Index Futures are also used to
hedge a Portfolio of shares and number of contracts depends upon the β of the portfolio.
5.2.3 Marking to Market
It implies the process of recording the investments in traded securities (shares, debt -instruments,
etc.) at a value, which reflects the market value of securities on the reporting date. In the context
of derivatives trading, the futures contracts are marked to market on periodic (or daily) basis.
Marking to market essentially means that at the end of a trading session, all outstanding contracts
are repriced at the settlement price of that session. Unlike the forward contracts, the future
contracts are repriced every day. Any loss or profit resulting from repricing would be debited or
credited to the margin account of the broker. It, therefore, provides an opportunity to calculate the
extent of liability on the basis of repricing. Thus, the futures contracts provide better risk
management measure as compared to forward contracts.
Suppose on 1st day we take a long position, say at a price of ` 100 to be matured on 7th day. Now
on 2nd day if the price goes up to ` 105, the contract will be repriced at ` 105 at the end of the
trading session and profit of ` 5 will be credited to the account of the buyer. This profit of ` 5 may
be drawn and thus cash flow also increases. This marking to market will result in three thing s –
one, you will get a cash profit of ` 5; second, the existing contract at a price of ` 100 would stand
cancelled; and third you will receive a new futures contract at ` 105. In essence, the marking to
market feature implies that the value of the futures contract is set to zero at the end of each
trading day.
5.2.4 Advantages of Futures Trading Vs. Stock Trading
Stock index futures is most popular financial derivatives over stock futures due to following
reasons:
1. It adds flexibility to one’s investment portfolio. Institutional investors and other large equity
holders prefer the most this instrument in terms of portfolio hedging purpose. The stock
systems do not provide this flexibility and hedging.
2. It creates the possibility of speculative gains using leverage. Because a relatively small
amount of margin money controls a large amount of capital represented in a stock index
contract, a small change in the index level might produce a profitable return on one’s
investment if one is right about the direction of the market. Speculative gains in stock futures
are limited but liabilities are greater.
3. Stock index futures are the most cost efficient hedging device whereas hedging through
individual stock futures is costlier.
4. Stock index futures cannot be easily manipulated whereas individual stock price can be
exploited more easily.
5. Since, stock index futures consists of many securities, so being an average stock, is much
less volatile than individual stock price. Further, it implies much lower cap ital adequacy and
margin requirements in comparison of individual stock futures. Risk diversification is possible
under stock index future than in stock futures.
6. One can sell contracts as readily as one buys them and the amount of margin required is th e
same.
7. In case of individual stocks the outstanding positions are settled normally against physical
delivery of shares. In case of stock index futures they are settled in cash all over the world
on the premise that index value is safely accepted as the settlement price.
8. It is also seen that regulatory complexity is much less in the case of stock index futures in
comparison to stock futures.
9. It provides hedging or insurance protection for a stock portfolio in a falling market.
5.2.5 Uses/Advantages of Stock Index Futures
Investors can use stock index futures to perform myriad tasks. Some common uses are:
(1) Investors commonly use stock index futures to change the weightings or risk exposures of
their investment portfolios. A good example of this is investors who hold equities from two
or more countries. Suppose these investors have portfolios invested in 60 percent U.S.
equities and 40 percent Japanese equities and want to increase their systematic risk to the
U.S. market and reduce these risks to the Japanese market. They can do this by buying
U.S. stock index futures contracts in the indexes underlying their holdings and selling
Japanese contracts (in the Nikkei Index).
(2) Stock index futures also allow investors to separate market timing from market selection
decisions. For instance, investors may want to take advantage of perceived immediate
increases in an equity market but are not certain which securities to buy; they can do this by
purchasing stock index futures. If the futures contracts are bought and the present value of
the money used to buy them is invested in risk-free securities, investors will have a risk
exposure equal to that of the market. Similarly, investors can adjust their portfolio holdings
at a more leisurely pace. For example, assume the investors see that they have several
undesirable stocks but do not know what holdings to buy to replace them. They can sell the
unwanted stocks and, at the same time, buy stock index futures to keep their exposure to
the market. They can later sell the futures contracts when they have decided which specific
stocks they want to purchase.
(3) Investors can also make money from stock index futures through index arbitrage, also referred
to as program trading as it is carried out through use of computers. Basically, arbitrage is the
purchase of a security or commodity in one market and the simultaneous sale of an equal
product in another market to profit from pricing differences. Investors taking part in stock index
arbitrage seek to gain profits whenever a futures contract is trading out of line with the fair price
of the securities underlying it. Thus, if a stock index futures contract is trading above its fair
value, investors could buy a basket of stocks composing the index in the correct proportion—
such as a mutual fund comprised of stocks represented in the index—and then sell the
expensively priced futures contract. Once the contract expires, the equities could then be sold
and a net profit would result. While the investors can keep their arbitrage position until the
futures contract expires, they are not required to. If the futures contract seems to be returning to
fair market value before the expiration date, it may be prudent for the investors to sell early.
(4) Investors often use stock index futures to hedge the value of their portfolios. Provide
hedging or insurance protection for a stock portfolio in a falling market. To implement a
hedge, the instruments in the cash and futures markets should have similar price
movements. Also, the amount of money invested in the cash and futures markets should be
the same. To illustrate, while investors owning well-diversified investment portfolios are
generally shielded from unsystematic risk (risk specific to particular firms), they are fully
exposed to systematic risk (risk relating to overall market fluctuations). A cost-effective way
for investors to reduce the exposure to systematic risk is to hedge with stock index futures,
similar to the way that people hedge commodity holdings using commodity futures.
Investors often use short hedges when they are in a long position in a stock portfolio and
believe that there will be a temporary downturn in the overall stock market. Hedging
transfers the price risk of owning the stock from a person unwilling to acce pt systematic
risks to someone willing to take the risk.
To carry out a short hedge, the hedger sells a futures contract; thus, the short hedge is also
called a "sell-hedge."
Example
Consider investors who own portfolios of securities valued at $.1.2 million with a dividend of
1 percent. The investors have been very successful with their stock picks. Therefore, while
their portfolios' returns move up and down with the market, they consistently outperform the
market by 6 percent. Thus, the portfolio would have a beta of 1.00 and an alpha of 6
percent. Say that the investors believe that the market is going to have a 15 percent
decline, which would be offset by the 1 percent received from dividends. The net broad
market return would be -14 percent but, since they consistently outperform the market by 6
percent, their estimated return would be -8 percent. In this instance, the investors would like
to cut their beta in half without necessarily cutting their alpha in half. They can achieve this
by selling stock index futures. In this scenario, the S&P 500 index is at 240. The contract
multiplier is $500, and therefore each contract represents a value of $120,000. Since the
investors want to simulate the sale of half of their $1.2 million portfolios, they must s ell five
contracts (5 × $120,000 = $600,000). Thus, their portfolios would be affected by only half of
the market fluctuation. While the investors could protect their portfolios equally well by
selling half of their shares of stock and buying them again at short time later, using a short
hedge on stock index futures is much cheaper than paying the capital gains tax plus the
broker commissions associated with buying and selling huge blocks of stock.
At the extreme, stock index futures can theoretically eliminate the effects of the broad
market on a portfolio. Perfect hedges are very unusual because of the existence of basis
risk. The basis is the difference between the existing price in the futures market and the
cash price of the underlying securities. Basis risk occurs when changes in the economy and
the financial situation have different impacts on the cash and futures markets.
(5) Stock index futures add flexibility to his or her portfolio as a hedging and trading instrument.
(6) Create the possibility of speculative gains using leverage. Because a relatively small
amount of margin money controls a large amount of capital represented in a stock index
contract, a small change in the index level might produce a profitable return on one’s
investment if he or she is right about the market's direction.
(7) Maintain one’s stock portfolio during stock market corrections. One may not need
"insurance" for all the time, but there are certain times when one would like less exposure
to stocks. Yet, one doesn't want to sell off part of a stock portfolio that has taken him or her
a long time to put together and looks like a sound, long-term investment program.
(8) One of the major advantages of futures markets, in general, is that one can sell contracts as
readily as he or she can buy them and the amount of margin required is the same. Mutual
funds do not specialize in bear market approaches by short selling stocks but, and also it is
not possible for individuals to short sell stocks in a falling market to make money.
(9) Transfer risk quickly and efficiently. Whether one is speculating, looking for insurance
protection (hedging), or temporarily substituting futures for a later cash transaction, most
stock index futures trades can be accomplished quickly and efficiently. Many mutual funds
require investors to wait until the end of the day to see at what price they were able to
purchase or sell shares. With today's volatility, once-a-day pricing may not give one the
maneuverability to take positions at exactly the time he or she wants. Stock index futures
give individual the opportunity to get into or out of a position whenever he or she wants.
6. OPTIONS
An Option may be understood as a privilege, sold by one party to another, that gives the buyer the
right, but not the obligation, to buy (call) or sell (put) any underlying say stock, foreign exchange,
commodity, index, interest rate etc. at an agreed-upon price within a certain period or on a specific
date regardless of changes in underlying’s market price during that period.
The various kinds of stock options include put and call options, which may be purchased in
anticipation of changes in stock prices, as a means of speculation or hedging. A put gives its
holder an option to sell, shares to another party at a fixed price even if the market price declines. A
call gives the holder an option to buy, or call for, shares at a fixed price even if the market price
rises.
6.1 Stock Options
Stock options involve no commitments on the part of the buyers of the option contracts individual
to purchase or sell the stock and the option is usually exercised only if the price of the stock has
risen (in case of call option) or fallen (in case of put option) above the price specified at the time
the option was given. One important difference between stocks and options is that stocks give you
a small piece of ownership in the company, while options are just contracts that give you the right
to buy or sell the stock at a specific price by a specific date. Investing in options provide limited
risk, high potential reward and smaller amount of capital required to control the same number of
shares which can be done via investing through cash market.
6.2 Stock Index Option
It is a call or put option on a financial index. Investors trading index options are essentially betting
on the overall movement of the stock market as represented by a basket of stocks.
Index options can be used by the portfolio managers to limit their downside risk. Suppose the
value of the index is S. Consider a manager in charge of a well diversified portfolio which has a β
of 1.0 so that its value mirrors the value of the index. If for each 100S rupees in the portfolio, the
manager buys one put option contract with exercise price X, the value of the portfolio is protected
against the possibility of the index falling below X. For instance, suppose that the manager’s
portfolio is worth ` 10,00,000 and the value of the index is 10000. The portfolio is worth 100 times
the index. The manager can obtain insurance against the value of the p ortfolio dropping below `
900,000 in the next two months by buying 1 put option contracts with a strike price of ` 9000. To
illustrate how this would work, consider the situation where the index drops to 8500. The portfolio
will be worth ` 850000 (100 x 8500). However, the payoff from the options will be 1 x (` 9000 – `
8500) x 100 = ` 50000, bringing the total value of the portfolio up to the insured value of `
9,00,000.
6.3 Parties to the Options
There are always two types of entities for an option transaction buyer and a seller (also known as
writer of the option) . So, for every call or put option purchased, there is always someone else
selling/buying it. When individuals sell options, they effectively create a security that didn't exist
before. This is known as writing an option and explains one of the main sources of options, since
neither the associated company nor the options exchange issues options. When you write a call,
you may be obligated to sell shares at the strike price any time before the exp iration date. When
you write a put, you may be obligated to buy shares at the strike price any time before expiration.
The price of an option is called its premium. The buyer of an option cannot lose more than the
initial premium paid for the contract, no matter what happens to the underlying security. So, the
risk to the buyer is never more than the amount paid for the option. The profit potential, on the
other hand, is theoretically unlimited
6.4 Premium for Options
In return for the premium received from the buyer, the seller of an option assumes the risk of
having to deliver (if a call option) or taking delivery (if a put option) of the shares of the stock.
Unless that option is covered by another option or a position in the underlying stock (opposite t o
the position taken via selling the option contracts), the seller's loss can be unlimited, meaning the
seller can lose much more than the original premium received.
6.5 Types of Options
You should be aware that there are two basic styles of options: American and European. An
American, or American-style, option can be exercised at any time between the date of purchase
and the expiration date. Most exchange-traded options are American style and all stock options
are American style. A European, or European-style, option can only be exercised on the expiration
date. In Indian Market most of the options are European style options.
6.6 Pay-off scenarios
The possible pay-off under various scenarios are as follows:
6.6.1 Pay-off for a Call Buyer

Also, called Long Call. For example, Mr. X buys a call option at strike price of Rs. 40 in exchange
of a premium of Rs. 5. In case if actual price of the stock at the time of exercise is less than Rs.
40, Mr. X would not exercise his option his loss would be Rs. 5. Mr. X would exercise his option at
any price above Rs. 40. In such situation his loss would start reducing and at the price of Rs. 45
there will be Break Even at the price of Rs. 45.
6.6.2 Pay-off for a Call Seller

Also, called Short Call. The pay-off profile of Call Seller shall be the mirror image of the Long Call
as shown below in dotted line.
6.6.3 Pay-off for a Put Buyer

Also, called Long Put. For example, Mr. X buys a put option at strike price of Rs. 40 in exchange of
a premium of Rs. 5. In case if actual price of the stock at the time of exercise is less than Rs. 40,
Mr. X would exercise his option his gain would be (Spot Price – Exercise Price – Premium). Mr. X
would exercise his option at any price below Rs. 40. The breakeven Break Even price will be Rs.
35 and Mr. X would not exercise his option for any price above Rs. 40.
6.6.4 Pay-off for a Put Seller

Also, called Short Put. For example, The pay-off profile of Put Seller shall be the mirror image of
the Long Put as shown below in dotted line.
6.7 Comparison with Single Stock Futures

Investing in stock futures differs from investing in equity options contracts in several ways:
• Nature: In options, the buyer of the options has the right but not the obligation to purchase
or sell the stock. However while going in for a long futures position, the investor is obligated
to square off his position at or before the expiry date of the futures contract.
• Movement of the Market: Options traders use a mathematical factor, the delta that
measures the relationship between the options premium and the price of the underlying
stock. At times, an options contract's value may fluctuate independently of the stock price.
In contrast, the future contract will much more closely follow the movement of the
underlying stock.
• The Price of Investing: When an options investor takes a long position, he or she pays a
premium for the contract. The premium is often called a sunk cost. At expiration, unless the
options contract is in the money, the contract is worthless and the investor has lost the
entire premium. Stock future contracts require an initial margin deposit and a specific
maintenance level of cash for mark to market margin
7. OPTION VALUATION TECHNIQUES

We have already been introduced to characteristics of both European and American Options.
Assuming a European Call Option on a non dividend paying stock it is easy to see that its value at
expiration date shall either be zero or the difference between the market price and the exercise
price, whichever is higher. It may be noted that the value of an Option cannot be negative. An
investor is required to pay a premium for acquiring such an Option. In case this premium is less
than the value of the Option, the investor shall make profits, however, in case the prem ium paid is
more than the value, the investor shall end up losing money. Note that, while measuring these
gains or losses, Time Value of Money and Transaction Costs have been ignored. The opposite
picture emerges for the Writer.
The Value of an Option with one period to expire: Simply speaking, the theoretical value of an
Option should be the difference between the current stock price and the exercise price. In case the
stock price is less than the exercise price the theoretical value shall be zero. However , as long as
there is time to expiration it is possible for a zero theoretical value Option to have some actual
positive Market value. This is because there may be a possibility of the stock price rising at which
point of time the Option may be exercised advantageously.
7.1 Binomial Model
The binomial model breaks down the time to expiration into potentially a very large number of time
intervals, or steps. This requires the use of probability and future discrete projections through
which a tree of stock prices is initially produced working forward from the present to expiration.
To facilitate understanding we shall restrict ourselves to a European Option having a one year time
branching process where at the end of the year there are only two possible values for the common
stock. One is higher and the other lower than the current value. Assume that the probability of the
two values to materialize is known. In such a situation, a hedged position can be established by
buying the stock and by writing Options. This shall help offset price movements. At each step, it is
assumed that the stock price will either move up or down. The pricing of the Options should be
such that the return equals the risk-free rate.
The above mentioned is an example of Binomial Distribution. When the number of high and low
value projections for the concerned stock are numerous, the tree shall represent all possible paths
that the stock price could take during the life of the option.
At the end of the tree - i.e. at expiration of the option - all the terminal option prices for each of the
final possible stock prices are known as they simply equal their intrinsic values.
The big advantage the binomial model has over the Black-Scholes model is that it can be used to
accurately price American options. This is because with the binomial model it's possible to check
at every point in an option's life (i.e. at every step of the binomial tree) for the possibility of early
exercise (e.g. where, due to e.g. a dividend, or a put being deeply in the money the option price at
that point is less than its intrinsic value).
Where an early exercise point is found it is assumed that the option holder would elect to exercise,
and the option price can be adjusted to equal the intrinsic value at that point. This then flows into
the calculations higher up the tree and so on.
Illustration 1
Following is a two sub-periods tree of 6-months each for the share of CAB Ltd.:
Now S1 One Period
36.30
33.00
30 29.70
27.00
24.30
Using the binomial model, calculate the current fair value of a regular call option on CAB Stock with the
following characteristics: X = ` 28, Risk Free Rate = 5 percent p.a. You should also indicate the
composition of the implied riskless hedge portfolio at the valuation date.
Solution
u = 33.00/30.00 = 36.30/33.00 = 1.10 d = 27.00/30.00 = 24.30/27.00 = 0.90
r = (1 + .05) 1/2 = 1.0247
r-d 1.0247 - 0.90
p= = = 0.1247/0.20 = 0.6235 (Prob. of increase in Price of Share)
u- d 1.10 - 0.90
Prob. of decrease in Price of Share = 1 – 0.6235 = 0.3765
Cuu = Max [0, 36.30 – 28] = 8.30

Cud = Max [0, 29.70 – 28] = 1.70
Cdd = Max [0, 24.30 – 28] = 0
( 0.6235 )( 8.30 ) + ( 0.3765 )(1.70 ) 5.175+ 0.640

CU = = = 5.815/1.025 = ` 5.673
1.025 1.025
( 0.6235 )(1.70 ) + ( 0.3765 )( 0.00 ) 1.05995
Cd = = = ` 1.0341
1.025 1.025
(0.6235)(5.673) + (0.3765)(1.0341) 3.537 + 0.3893
Co = = = ` 3.83
1.025 1.025
The composition of the implied risk-less hedge portfolio at valuation date is called Delta (∆) and it
is calculated as follows:
Cu - C d
SU - S d
Where,
Cu = Pay-off from Call Option if price of Stock goes up
Cd = Pay-off from Call Option if price of Stock goes down
Su = Upward price of the Stock
Sd = Downward price of the Stock
Accordingly, the Risk-less Portfolio shall require ∆ Share shall be required for writing off one Call
Option. The ∆ shall be computed as follows:
5-0 5
∆= =
33- 27 6
5
Thus, shares shall be held or purchased for writing one Call Option.
6
7.2 Risk Neutral Method

The “risk-neutral” technique can also be used to value derivative securities. It was developed by
John Cox and Stephen Ross in 1976. The basic argument in the risk neutral approach is that since
the valuation of options is based on arbitrage and is therefore independent of risk preferences; one
should be able to value options assuming any set of risk preferences and get the same answer as
by using Binomial Model. This model is a simple model.
Example
Suppose the price of the share of Company X is ` 50. In one year it is expected either to go up to
` 60 or go down to ` 40. The risk free rate of interest is 5%.
Let p be the probability that the price will increase then (1-p) will be probability of price decrease.
The value of the stock today must be equal to the present value of the expected price after one
year discounted at risk-free rate as follows:
60p + 40(1- p)
50 =
1.05
On solving we shall get the value of p= 0.625. With this value we can find out the present value of
the expected payout as follows:
10(0.625) + 0(1 - 0.625)
= 5.95
1.05
It may however be noted that the discounting can also be made on daily basis as shown in
following illustration.
Illustration 2
The current market price of an equity share of Penchant Ltd is ` 420. Within a period of 3 months,
the maximum and minimum price of it is expected to be ` 500 and ` 400 respectively. If the risk
free rate of interest be 8% p.a., what should be the value of a 3 months Call option under the “Risk
Neutral” method at the strike rate of ` 450 ? Given e0.02 = 1.0202
Solution
Let the probability of attaining the maximum price be p
(500 - 420) х p+(400 - 420) х (1-p) = 420 х (e0.02-1)
or, 80p - 20(1 - p) = 420 х 0.0202
or, 80p – 20 + 20p = 8.48
or, 100p = 28.48
p= 0.2848
0.2848x(500 − 450) 0.2848x50

The value of Call Option in ` = = =13.96
1.0202 1.0202
7.3 Black-Scholes Model

The Black-Scholes model is used to calculate a theoretical price of an Option. The Black-Scholes
price is nothing more than the amount an option writer would require as compensation for writing a
call and completely hedging the risk of buying stock. The important point is that the hedger's view
about future stock prices is irrelevant. Thus, while any two investors may strongly disagree on the
rate of return they expect on a stock they will, given agreement to the assumptions of volatility and
the risk-free rate, always agree on the fair value of the option on that underlying asset. This key
concept underlying the valuation of all derivatives -- that fact that the price of an option is
independent of the risk preferences of investors -- is called risk-neutral valuation. It means that all
derivatives can be valued by assuming that the return from their underlying assets is the risk-free
rate.
The model is based on a normal distribution of underlying asset returns.
The following assumptions accompany the model:
1. European Options are considered,
2. No transaction costs,
3. Short term interest rates are known and are constant,
4. Stocks do not pay dividend,
5. Stock price movement is similar to a random walk,
6. Stock returns are normally distributed over a period of time, and
7. The variance of the return is constant over the life of an Option.
The original formula for calculating the theoretical option price (OP) is as follows:
Where:
The variables are:

S = current stock price
X = strike price of the option
t = time remaining until expiration, expressed as a percent of a year

r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of the short-term returns
over one year).
ln = natural logarithm
N(x) = standard normal cumulative distribution function (Area under Normal Curve)
e = the exponential function
Understanding the formula
N(d1) represents the hedge ratio of shares of stock to Options necessary to maintain a fully
hedged position.
Consider the Option holder as an investor who has borrowed an equivalent amount of the exercise
price at interest rate r. Xe-rtN(d2) represents this borrowing which is equivalent to the present
value of the exercise price times an adjustment factor of N(d 2)
The main advantage of the Black-Scholes model is speed -- it lets you calculate a very large
number of option prices in a very short time.
The Black-Scholes model has one major limitation that it cannot be used to accurately price
options with an American-style exercise as it only calculates the option price at one point of time --
at expiration. It does not consider the steps along the way where there could be the possibility of
early exercise of an American option.
Illustration 3
(i) The shares of TIC Ltd. are currently priced at ` 415 and call option exercisable in three
months’ time has an exercise rate of ` 400. Risk free interest rate is 5% p.a. and standard
deviation (volatility) of share price is 22%. Based on the assumption that TIC Ltd. is not
going to declare any dividend over the next three months, is the option worth buying for `
25?
(ii) Calculate value of aforesaid call option based on Block Scholes valuation model if the
current price is considered as ` 380.
(iii) What would be the worth of put option if current price is considered ` 380.
(iv) If TIC Ltd. share price at present is taken as ` 408 and a dividend of ` 10 is expected to be
paid in the two months time, then, calculate value of the call option.
Solution
(i) Given: TIC Ltd. Current Price = ` 415
Exercise rate = 400
Risk free interest rate is = 5% p.a.

SD (Volatility) = 22%
Based on the above bit is calculated value of an option based on Block Scholes Model:
 415   1 2
l  +
n  400  .05 + 2 (.22)  .25
d =
1 .22 .25 .03681 + .01855
= = .5032727
.11
 415   1 2
ln 

+
400  .05 - 2 (.22)  .25 .03681 + .00645
d2 = = = .3932727
.22 .25 .11
N(d1) = N (.50327) = 1 − .3072 = .6928

N(d2) = N (.39327) = 1 − .3471 = .6529
400
Value of Option = 415 (.6928) - (.05) (.25)
(.6529)
e
400
= 287.512 - (.6529) = 287.512 – 257.916 = ` 29.60
1.012578
NB : N(0.39327) can also be find as under :
Step 1: From table of area under normal curve find the area of variable 0.39 i.e. 0.6517.
Step 2: From table of area under normal curve find the area of variable 0.40.
Step 3: Find out the difference between above two variables and areas under normal
curve.
Step 4 : Using interpolation method find out the value of 0.00327. Which is as follows:
0.0037
 0.00327 = 0.0012
0.01
Step 5: Add this value, computed above to the N(0.39). Thus N (0.39327)
= 0.6517 + 0.0012 = 0.6529
Since market price of ` 25 is less than ` 27.60 (Block Scholes Valuation model) indicate
that option is underpriced, hence worth buying.
(ii) If the current price is taken as ` 380 the computations are as follows:
 380   1 2
ln 

+
400  .05 + 2 (.22)  .25 -0.05129 + .01855
d1 = = = -0.297636
.22 .25 .11
 380   1 2
ln 

+
400  .05 - 2 (.22)  .25 -0.05129 + .00645
d2 = = = -0.407636
.22 .25 .11
E
Vo = Vs N(d1) - N(d2)
ert
N(d1) = N(-0.297636) = .3830
N(d2) = N(-0.407636) = .3418
400
380 (.3830) - (.05 ) (.25 )
 (.3418)
e
400
145.54 - (.3418) = 145.54 – 135.02 = ` 10.52
1.012578
(iii) Value of call option = ` 10.52
Current Market Value = ` 415
400 400
Present Value of Exercise Price = = 395.06 or = 395.03
1.0125 1.012578
Value of Put Option can be find by using Put Call Parity relationship as follows:
Vp = -Vs + Vc + PV (E)
Vp = -380 + 10.52 + 395.06 = 25.58
= ` 25.58 Ans
or -380 + 10.52 + 395.03 = 25.55
= ` 25.55
(iv) Since dividend is expected to be paid in two months time we have to adjust the share price
and then use Block Scholes model to value the option:
Present Value of Dividend (using continuous discounting) = Dividend  e-rt
= ` 10  e-.05  .16666
= ` 10  e-.008333
= ` 9.917 (Please refer Exponential Table)
Adjusted price of shares is ` 408 – 9.917 = ` 398.083
This can be used in Block Scholes model
 398.083  
ln   + .05 +
1
(.22)2  .25
400 2 -.00480 + .01855
d1 =     = = .125
.22 .25 .11
 398.083   1 2
ln   + .05 - (.22)  .25 -.00480 + .00645
400 2
d2 =     =
.11 = .015
.22 .25
N(d1) = N(.125) = .5498
N(d2) = N(.015) = .5060
400
Value of Option = 398.0 83 (.5498) - (.5060)
e (.05) (.25)
400
218.866 - (.5060)
e.0125
400
218.866 - (.5060) = 218.866 – 199.8858= ` 18.98
1.012578
7.4 Greeks
The Greeks are a collection of statistical values (expressed as percentages) that give the investor
a better overall view of how a stock has been performing. These statistical values can be helpful in
deciding what options strategies are best to use. The investor should remember that statistics
show trends based on past performance. It is not guaranteed that the future performance of the
stock will behave according to the historical numbers. These trends can change drastically based
on new stock performance.
Before we discuss these statistical measures let us discuss the factors that affects the value of
option as these statistical measures are related to changes in the in these factors.
7.4.1 Factors Affecting Value of an Option
There are a number of different mathematical formulae, or models, that are designed to compute
the fair value of an option. You simply input all the variables (stock price, time, interest rates,
dividends and future volatility), and you get an answer that tells you what an option should be
worth. Here are the general effects the variables have on an option's price:
(a) Price Movement of the Underlying: The value of calls and puts are affected by changes in
the underlying stock price in a relatively straightforward manner. When the stock price goes up,
calls should gain in value and puts should decrease. Put options should increase in value and calls
should drop as the stock price falls.
(b) Time till expiry: The option's future expiry, at which time it may become worthless, is an
important and key factor of every option strategy. Ultimately, time can determine whether your
option trading decisions are profitable. To make money in options over the long term, you need to
understand the impact of time on stock and option positions.
With stocks, time is a trader's ally as the stocks of quality companies tend to rise over long periods
of time. But time is the enemy of the options buyer. If days pass without any significant change in
the stock price, there is a decline in the value of the option. Also, the value of an option declines
more rapidly as the option approaches the expiration day. That is good news for the option seller,
who tries to benefit from time decay, especially during that final month when it occurs most rapid ly.
(c) Volatility in Stock Prices: Volatility can be understood via a measure called Statistical
(sometimes called historical) Volatility, or SV for short. SV is a statistical measure of the past price
movements of the stock; it tells you how volatile the stock has actually been over a given period of
time.
But to give you an accurate fair value for an option, option pricing models require you to put in
what the future volatility of the stock will be during the life of the option. Naturally, option trader s
don't know what that will be, so they have to try to guess. To do this, they work the options pricing
model "backwards" (to put it in simple terms). After all, you already know the price at which the
option is trading; you can also find the other variables (stock price, interest rates, dividends, and
the time left in the option) with just a bit of research. So, the only missing number is future
volatility, which you can calculate from the equation.
(d) Interest Rate- Another feature which affects the value of an Option is the time value of
money. The greater the interest rates, the present value of the future exercise price are less.
Now let us discuss these measures.
7.4.2 Delta
A by-product of the Black-Scholes model is the calculation of the delta. It is the degree to which an
option price will move given a small change in the underlying stock price. For example, option
price (with a delta of 0.5) will move half a rupee for every full rupee movement in the underlying
stock.
A deeply out-of-the-money call will have a delta very close to zero; a deeply in-the-money call will
have a delta very close to 1.
The formula for a delta of a European call on a non-dividend paying stock is:
Delta = N (d1) (see Black-Scholes formula above for d1)
Call Deltas are positive; Put Deltas are negative, reflecting the fact that the Put option price and
the underlying stock price are inversely related. The Put Delta is equal to (Call Delta – 1).
As discussed earlier the delta is often called the Hedge Ratio. If you have a portfolio short ‘n’
options (e.g. you have written n calls) then n multiplied by the delta gives you the number of
shares (i.e. units of the underlying) you would need to create a riskless position - i.e. a portfolio
which would be worth the same whether the stock price rose by a very small amount or fell by a
very small amount. In such a "delta neutral" portfolio any gain in the value of the shares held due
to a rise in the share price would be exactly offset by a loss on the value of the calls writ ten, and
vice versa.
Note that as the Delta changes with the stock price and time to expiration the number of shares
would need to be continually adjusted to maintain the hedge. How quickly the delta changes with
the stock price are given by ‘Gamma’.
In addition to Delta there are some other "Greeks" which some find useful when constructing
option strategies.
7.4.3 Gamma
It measures how fast the Delta changes for small changes in the underlying stock price i.e. the
Delta of the Delta. If you are hedging a portfolio using the Delta-hedge technique then you will
want to keep gamma as small as possible, the smaller it is the less often you will have to adjust
the hedge to maintain a delta neutral position. If gamma is too large, a small change in stock price
could wreck your hedge. Adjusting gamma, however, can be tricky and is generally done using
options i.e. it cannot be done by selling or buying underlying asset rather by selling or buying
options.
7.4.4 Theta
The change in option price given a one day decrease in time to expiration. Basically it is a
measure of time decay. Unless you and your portfolio are travelling at close to the speed of light
the passage of time is constant and inexorable. Thus, hedging a portfolio against time decay, the
effects of which are completely predictable, would be pointless.
7.4.5 Rho
The change in option price given a one percentage point change in the risk -free interest rate. It is
sensitivity of option value to change in interest rate. Rho indicates the absolute change in o ption
value for a one percent change in the interest rate. For example, a Rho of .060 indicates the
option's theoretical value will increase by .060 if the interest rate is decreased by 1.0.
7.4.6 Vega
Sensitivity of option value to change in volatility. Vega indicates an absolute change in option
value for a one percent change in volatility. For example, a Vega of .090 indicates an absolute
change in the option's theoretical value will increase by .090 if the volatility percentage is
increased by 1.0 or decreased by .090 if the volatility percentage is decreased by 1.0. Results may
not be exact due to rounding. It can also be stated as the change in option price given a one
percentage point change in volatility. Like delta and gamma, Vega is also used for h edging.
8. COMMODITY DERIVATIVES
Trading in commodity derivatives first started to protect farmers from the risk of the value of their
crop going below the cost price of their produce. Derivative contracts were offered on various
agricultural products like cotton, rice, coffee, wheat, pepper etc.
The first organized exchange, the Chicago Board of Trade (CBOT) -- with standardized contracts
on various commodities -- was established in 1848. In 1874, the Chicago Produce Exchange -
which is now known as Chicago Mercantile Exchange (CME) was formed.
CBOT and CME are two of the largest commodity derivatives exchanges in the world.
8.1 Necessary Conditions to Introduce Commodity Derivatives
The commodity characteristic approach defines feasible commodities for derivatives trading based
on an extensive list of required commodity attributes. It focuses on the technical aspects of the
underlying commodity. The following attributes are considered crucial for qualifying for the
derivatives trade:
1) a commodity should be durable and it should be possible to store it;
2) units must be homogeneous;
3) the commodity must be subject to frequent price fluctuations with wide amplitude; supply
and demand must be large;
4) supply must flow naturally to market and there must be breakdowns in an existing pattern of
forward contracting.
The first attribute, durability and storability, has received considerable attention in commodity
finance, since one of the economic functions often attributed to commodity derivatives markets is
the temporal allocation of stocks. The commodity derivatives market is an integral part of this
storage scenario because it provides a hedge against price risk for the carrier of stocks.
Since commodity derivatives contracts are standardized contracts, this approach requires the
underlying product to be homogeneous, the second attribute, so that the underlying commodity as
defined in the commodity derivatives contract corresponds with the commodity traded in the cash
market. This allows for actual delivery in the commodity derivatives market.
The third attribute, a fluctuating price, is of great importance, since firms will feel little incentive to
insure themselves against price risk if price changes are small. A broad cash market is important
because a large supply of the commodity will make it difficult to establish dominance in the market
place and a broad cash market will tend to provide for a continuous and orderly meeting of supply
and demand forces.
The last crucial attribute, breakdowns in an existing pattern of forward trading, indicates that cash
market risk will have to be present for a commodity derivatives market to come into existence.
Should all parties decide to eliminate each and every price fluctuation by using cash forward
contracts for example, a commodity derivatives market would be of little interest.
A commodity derivative must reflect the commercial movement of a commodity both loosely and
broadly enough, so that price distortions will not be a result of specifications in the contra ct. To
warrant hedging, the contract must be as close a substitute for the cash commodity as possible.
Hedging effectiveness is an important determinant in explaining the success of commodity
derivatives and as a result considerable attention has been paid to the hedging effectiveness of
commodity derivatives.
The total set of customer needs concerning commodity derivatives is differentiated into
instrumental needs and convenience needs (see Figure 1). Customers will choose that “service-
product” (futures, options, cash forwards, etc.) which best satisfy their needs, both instrumental
and convenience, at an acceptable price.
FIGURE 1
Instrumental needs are the hedgers’ needs for price risk reduction. Hedgers wish to reduce, or, if
possible, eliminate portfolio risks at low cost. The instrumental needs are related to the core
service of the commodity derivatives market, which consists of reducing price variability to the
customer. Not only do hedgers wish to reduce price risk, they also desire flexibility in doing
business, easy access to the market, and an efficient clearing system. These needs are called
convenience needs. They deal with the customer’s need to be able to use the core service
provided by the exchange with relative ease. The extent to which the commodity derivatives
exchange is able to satisfy convenience needs determines the process quality. The service
offering is not restricted to the core service, but has to be complemented by so -called peripheral
services.
8.2 Investing in Commodity Derivatives
Commodity derivatives, which were traditionally developed for risk management purposes, are
now growing in popularity as an investment tool. Most of the trading in the commodity derivatives
market is being done by people who have no need for the commodity itself.
They just speculate on the direction of the price of these commodities, hoping to make money if
the price moves in their favour.
The commodity derivatives market is a direct way to invest in commodities rather than investing in
the companies that trade in those commodities.
For example, an investor can invest directly in a steel derivative rather than investing in the shares
of Tata Steel. It is easier to forecast the price of commodities based on their demand and supply
forecasts as compared to forecasting the price of the shares of a company which depend on many
other factors than just the demand and supply of the products they manufacture and sell or trade
in.
Also, derivatives are much cheaper to trade in as only a small sum of money is req uired to buy a
derivative contract.
Let us assume that an investor buys a tonne of soybean for ` 8,700 in anticipation that the prices
will rise to ` 9,000 by June 30, 2013. He will be able to make a profit of ` 300 on his investment,
which is 3.4%. Compare this to the scenario if the investor had decided to buy soybean futures
instead.
Before we look into how investment in a derivative contract works, we must familiarise ourselves
with the buyer and the seller of a derivative contract. A buyer of a derivat ive contract is a person
who pays an initial margin to buy the right to buy or sell a commodity at a certain price and a
certain date in the future.
On the other hand, the seller accepts the margin and agrees to fulfill the agreed terms of the
contract by buying or selling the commodity at the agreed price on the maturity date of the
contract.
Now let us say the investor buys soybean futures contract to buy one tonne of soybean for ` 8,700
(exercise price) on November 30, 2013. The contract is available by paying an initial margin of
10%, i.e. ` 870. Note that the investor needs to invest only ` 870 here.
On November 30, 2013, the price of soybean in the market is, say, ` 9,000 (known as Spot Price -
- Spot Price is the current market price of the commodity at any point in time).
The investor can take the delivery of one tonne of soybean at ` 8,700 and immediately sell it in the
market for ` 9,000, making a profit of ` 300. So the return on the investment of ` 870 is 34.5%.
On the contrary, if the price of soybean drops to ` 8,400 the investor will end up making a loss of
34.5%.
If the investor wants, instead of taking the delivery of the commodity upon maturity of the contract,
an option to settle the contract in cash also exists. Cash settlement comprises exc hange of the
difference in the spot price of the commodity and the exercise price as per the futures contract.
At present, the option of cash settlement lies only with the seller of the contract. If the seller
decides to make or take delivery upon maturity, the buyer of the contract has to fulfill his obligation
by either taking or making delivery of the commodity, depending on the specifications of the
contract.
In the above example, if the seller decides to go for cash settlement, the contract can be sett led by
the seller by paying ` 300 to the buyer, which is the difference in the spot price of the commodity
and the exercise price. Once again, the return on the investment of ` 870 is 34.5%.
The above example shows that with very little investment, the commodity futures market offers scope to
make big bucks. However, trading in derivatives is highly risky because just as there are high returns to
be earned if prices move in favour of the investors, an unfavourable move results in huge losses.
The most critical function in a commodity derivatives exchange is the settlement and clearing of
trades. Commodity derivatives can involve the exchange of funds and goods. The exchanges have
a separate body to handle all the settlements, known as the clearing house.
For example, the holder of a futures contract to buy soybean might choose to take delivery of soya
bean rather than closing his position before maturity. The function of the clearing house or clearing
organisation, in such a case, is to take care of possible problems of default by the other party
involved by standardising and simplifying transaction processing between participants and the
organisation.
Certain special characteristics/benefits of Commodity derivatives trading are:
❖ To complement investment in companies that use commodities;
❖ To invest in a country’s consumption and production;
❖ No dividends, only returns from price increases.
In spite of the surge in the turnover of the commodity exchanges in recent years, a lot of work in
terms of policy liberalisation, setting up the right legal system, creating the necessary
infrastructure, large-scale training programs, etc. still needs to be done in order to catch up with
the developed commodity derivative markets.
8.3 Commodity Market
Commodity markets in a crude early form are believed to have originated in Sumer where small
baked clay tokens in the shape of sheep or goats were used in trade. Sealed in clay vessels with a
certain number of such tokens, with that number written on the outside, they represented a
promise to deliver that number.
In modern times, commodity markets represent markets where raw or primary products are
exchanged. These raw commodities are traded on regulated, commodity exchanges in which they
are bought and sold in standardized contracts.
Some of the advantages of commodity markets are:
❖ Most money managers prefer derivatives to tangible commodities;
❖ Less hassle (delivery, etc);
❖ Allows indirect investment in real assets that could provide an additional hedge against
inflation risk.
8.4 Commodity Futures

Almost all the commodities were allowed to be traded in the futures market from April 2003. To
make trading in commodity futures more transparent and successful, multi-commodity exchanges
at national level were also conceived and these next generation exchanges were allowed to start
futures trading in commodities on-line.
The process of trading commodities is also known as Futures Trading. Unlike other kinds of
investments, such as stocks and bonds, when you trade futures, you do not actual ly buy anything
or own anything. You are speculating on the future direction of the price in the commodity you are
trading. This is like a bet on future price direction. The terms "buy" and "sell" merely indicate the
direction you expect future prices will take.
If, for instance, you were speculating in corn, you would buy a futures contract if you thought the
price would be going up in the future. You would sell a futures contract if you thought the price
would go down. For every trade, there is always a buyer and a seller. Neither person has to own
any corn to participate. He must only deposit sufficient capital with a brokerage firm to insure that
he will be able to pay the losses if his trades lose money.
On one side of a transaction may be a producer like a farmer. He has a field full of corn growing on
his farm. It won't be ready for harvest for another three months. If he is worried about the price
going down during that time, he can sell futures contracts equivalent to the size of his crop and
deliver his corn to fulfill his obligation under the contract. Regardless of how the price of corn
changes in the three months until his crop will be ready for delivery, he is guaranteed to be paid
the current price.
On the other side of the transaction might be a producer such as a cereal manufacturer who needs
to buy lots of corn. The manufacturer, such as Kellogg, may be concerned that in the next three
months the price of corn will go up, and it will have to pay more than the current price. To protect
against this, Kellogg can buy futures contracts at the current price. In three months Kellogg can
fulfill its obligation under the contracts by taking delivery of the corn. This guarantees that
regardless of how the price moves in the next three months, Kellogg wi ll pay no more than the
current price for its commodity.
In addition to agricultural commodities, there are futures for financial instruments and intangibles
such as currencies, bonds and stock market indexes. Each futures market has producers and
consumers who need to hedge their risk from future price changes. The speculators, who do not
actually deal in the physical commodities, are there to provide liquidity. This maintains an orderly
market where price changes from one trade to the next are small.
Rather than taking delivery or making delivery, the speculator merely offsets his position at some
time before the date set for future delivery. If price has moved in the right direction, he will earn
profit, if not, he will lose.
Advantages of Commodity Futures

Some of the advantages of commodity futures are:
• Easiest and cheapest way to invest in commodities
• 3 Major Categories like Agricultural products (soft commodities) –fibers, grains, food,
livestock; Energy – crude oil, heating oil, natural gas; and Metals – copper, aluminum, gold,
silver, platinum
8.5 Commodity Swaps
Producers need to manage their exposure to fluctuations in the prices for their commodities. They
are primarily concerned with fixing prices on contracts to sell their produce. A gold producer wants
to hedge his losses attributable to a fall in the price of gold for his current gold inventory. A cattle
farmer wants to hedge his exposure to changes in the price of his livestock.
End-users need to hedge the prices at which they can purchase these commodities. A university
might want to lock in the price at which it purchases electricity to supply its air conditioning units
for the upcoming summer months. An airline wants to lock in the price of the jet fuel it needs to
purchase in order to satisfy the peak in seasonal demand for travel.
Speculators are funds or individual investors who can either buy or sell commodities by
participating in the global commodities market. While many may argue that their involvement is
fundamentally destabilizing, it is the liquidity they provide in normal markets that facilitates the
business of the producer and of the end-user.
Why would speculators look at the commodities markets? Traditionally, they may have wanted a
hedge against inflation. If the general price level is going up, it is probably attributable to increases
in input prices. Or, speculators may see tremendous opportunity in commodity markets. Some
analysts argue that commodity markets are more technically-driven or more likely to show a
persistent trend.
8.5.1 Types of Commodity Swaps
There are two types of commodity swaps: fixed-floating or commodity-for-interest.
(a) Fixed-Floating Swaps: They are just like the fixed-floating swaps in the interest rate swap
market with the exception that both indices are commodity based indices.
General market indices in the international commodities market with which many people would be
familiar include the S&P Goldman Sachs Commodities Index (S&PGSCI) and the Commodities
Research Board Index (CRB). These two indices place different weights on the various
commodities so they will be used according to the swap agent's requirements.
(b) Commodity-for-Interest Swaps: They are similar to the equity swap in which a total return
on the commodity in question is exchanged for some money market rate (plus or minus a spread).
8.5.2 Valuing Commodity Swaps

In pricing commodity swaps, we can think of the swap as a strip of forwards, each priced at
inception with zero market value (in a present value sense). Thinking of a sw ap as a strip of at-the-
money forwards is also a useful intuitive way of interpreting interest rate swaps or equity swaps.
Commodity swaps are characterized by some peculiarities. These include the following factors for
which we must account:
(i) The cost of hedging;
(ii) The institutional structure of the particular commodity market in question;
(iii) The liquidity of the underlying commodity market;
(iv) Seasonality and its effects on the underlying commodity market;
(v) The variability of the futures bid/offer spread;
(vi) Brokerage fees; and
(vii) Credit risk, capital costs and administrative costs.
Some of these factors must be extended to the pricing and hedging of interest rate swaps,
currency swaps and equity swaps as well. The idiosyncratic nature of the commodity markets
refers more to the often limited number of participants in these markets (naturally begging
questions of liquidity and market information), the unique factors driving these markets, the inter -
relations with cognate markets and the individual participants in these markets.
8.6 Hedging with Commodity Derivatives
Many times when using commodity derivatives to hedge an exposure to a financial price, there is
not one exact contract that can be used to hedge the exposure. If you are trying to hedge the
value of a particular type of a refined chemical derived from crude oil, you may not find a listed
contract for that individual product. You will find an over-the-counter price if you are lucky.
They look at the correlation (or the degree to which prices in the individ ual chemical trade with
respect to some other more liquid object, such as crude oil) for clues as to how to price the OTC
product that they offer you. They make assumptions about the stability of the correlation and its
volatility and they use that to "shade" the price that they show you.
Correlation is an un-hedgable risk for the OTC market maker, though. There is very little that he
can do if the correlation breaks down.
For example, if all of a sudden the price for your individual chemical starts dropp ing faster than the
correlation of the chemical's price with crude oil suggests it should, the OTC dealer has to start
dumping more crude oil in order to compensate.
It is a very risky business. The OTC market maker's best hope is to see enough "two -way"
business involving end-users and producers so that his exposure is "naturally" hedged by people
seeking to benefit from price movement in either direction.
Commodity swaps and commodity derivatives are a useful and important tool employed by most
leading energy, chemical and agricultural corporations in today’s world.
Note: Please note other forms of Swaps such as Currency Swap and Interest Rate Swap have
been discussed in the respective chapters.
9. EMBEDDED DERIVATIVES
An embedded derivative is a derivative instrument that is embedded in another contract - the host
contract. The host contract might be a debt or equity instrument, a lease, an insurance contract or
a sale or purchase contract. Derivatives require to be marked-to-market through the income
statement, other than qualifying hedging instruments. This requirement on embedded derivatives
are designed to ensure that mark-to-market through the income statement cannot be avoided by
including - embedding - a derivative in another contract or financial instrument that is not marked-
to market through the income statement.
A coal purchase contract may include a clause that links the price of the coal to a pricing formula
based on the prevailing electricity price or a related index at the date of delive ry. The coal
purchase contract, which qualifies for the executory contract exemption, is described as the host
contract, and the pricing formula is the embedded derivative. The pricing formula is an embedded
derivative because it changes the price risk from the coal price to the electricity price.
An embedded derivative that modifies an instrument's inherent risk (such as a fixed to floating
interest rate swap) would be considered closely related. Conversely, an embedded derivative that
changes the nature of the risks of a contract is not closely related.
Most equity- or commodity-linked features embedded in a debt instrument will not be closely
related. This includes puts that force the issuer to reacquire an instrument based on changes in
commodity price or index, equity or commodity indexed interest or principal payments and equity
conversion features. Puts or calls on equity instruments at specified prices (that is, not market on
date of exercise) are seldom closely related, neither are calls, puts or prepayment penalties on
debt instruments. Credit derivatives embedded in a host debt instrument are seldom closely
related to it.
The economic characteristics and risks of an embedded derivative are closely related to the
economic characteristics and risks of the host contract when the host contract is a debt instrument
and the embedded derivative is an interest rate floor or a cap out of the money when the
instrument is issued. An entity would not account for the embedded derivative separately from the
host contract. The same principle applies to caps and floors in a sale or purchase contract.
Closely related- Examples of embedded derivatives that need not be separated
A derivative embedded in a host lease contract is closely related to the host contract if the
embedded derivative comprises contingent rentals based on related sales;
An inflation index term in a debt instrument as long as it is not leveraged and relates to the
inflation index in the economic environment in which the instrument is denominated or issued;
Not closely related- Examples of embedded derivatives that must be separated
Equity conversion feature embedded in a debt instrument e.g. investment in convertible bonds;
Option to extend the term of a debt instrument unless there is a concurren t adjustment of the
interest rate to reflect market prices;
Equity-indexed interest embedded in a debt instrument
Fair Valuing Embedded Derivatives: Embedded derivatives that are separated from the host
contract are accounted for at fair value with changes in fair value taken through the income
statement. Published price quotations in an active market are normally the best evidence of fair
value.
Valuation techniques are used to determine the fair value of the derivative if there is no active
market that matches the exact terms of the embedded derivative.
In the case of option derivatives (e.g. puts & calls), the embedded derivatives should be separated
from the host contract and valued based on the stated terms of the option. It is assumed that an
option derivative will not normally have a fair value of zero initial recognition. In the case of non-
option derivatives, the embedded derivatives should be separated from the host contract based on
its stated and implied terms and is assumed to have a fair value of zero at initial recognition.
TEST YOUR KNOWLEDGE

1. What are the reasons for stock index futures becoming more popular financial derivatives
over stock futures segment in India?
2. Write short note on Marking to market.
3. State any four assumptions of Black Scholes Model.

4. Write short note on Embedded derivatives.
5. Define the term Greeks with respect to options.
Practical Questions
1. The 6-months forward price of a security is ` 208.18. The borrowing rate is 8% per annum
payable with monthly rests. What should be the spot price?
2. The following data relate to Anand Ltd.'s share price:
Current price per share ` 1,800
6 months future's price/share ` 1,950
Assuming it is possible to borrow money in the market for transactions in securities at 12%
per annum, you are required:
(i) to calculate the theoretical minimum price of a 6-months forward purchase; and
(ii) to explain arbitrate opportunity.
3. On 31-8-2011, the value of stock index was ` 2,200. The risk free rate of return has been
8% per annum. The dividend yield on this Stock Index is as under:
Month Dividend Paid p.a.
January 3%
February 4%
March 3%
April 3%
May 4%
June 3%
July 3%
August 4%
September 3%
October 3%
November 4%
December 3%
Assuming that interest is continuously compounded daily, find out the future price of
contract deliverable on 31-12-2011. Given: e 0.01583 = 1.01593
4. Calculate the price of 3 months PQR futures, if PQR (FV `10) quotes `220 on NSE and the
three months future price quotes at `230 and the one month borrowing rate is given as 15
percent and the expected annual dividend is 25 percent per annum payable before expiry.
Also examine arbitrage opportunities.
5.
BSE 5000
Value of portfolio ` 10,10,000
Risk free interest rate 9% p.a.
Dividend yield on Index 6% p.a.
Beta of portfolio 1.5
We assume that a future contract on the BSE index with four months maturity is used to hedge
the value of portfolio over next three months. One future contract is for delivery of 50 times the
index.
Based on the above information calculate:
(i) Price of future contract.
(ii) The gain on short futures position if index turns out to be 4,500 in three months.
6. The share of X Ltd. is currently selling for ` 300. Risk free interest rate is 0.8% per month.
A three months futures contract is selling for ` 312. Develop an arbitrage strategy and show
what your riskless profit will be 3 month hence assuming that X Ltd. will not pay any
dividend in the next three months.
7. A Mutual Fund is holding the following assets in ` Crores :
Investments in diversified equity shares 90.00
Cash and Bank Balances 10.00
100.00
The Beta of the equity shares portfolio is 1.1. The index future is selling at 4300 level. The
Fund Manager apprehends that the index will fall at the most by 10%. How many index
futures he should short for perfect hedging? One index future consists of 50 units.
Substantiate your answer assuming the Fund Manager's apprehension will materialize.
8. A trader is having in its portfolio shares worth ` 85 lakhs at current price and cash ` 15
lakhs. The beta of share portfolio is 1.6. After 3 months the price of shares dropped by
3.2%.
Determine:
(i) Current portfolio beta
(ii) Portfolio beta after 3 months if the trader on current date goes for long position on
` 100 lakhs Nifty futures.
9. Which position on the index future gives a speculator, a complete hedge against the
following transactions:
(i) The share of Right Limited is going to rise. He has a long position on the cash
market of ` 50 lakhs on the Right Limited. The beta of the Right Limited is 1.25.
(ii) The share of Wrong Limited is going to depreciate. He has a short position on the
cash market of ` 25 lakhs on the Wrong Limited. The beta of the Wrong Limited is
0.90.
(iii) The share of Fair Limited is going to stagnant. He has a short position on the cash
market of ` 20 lakhs of the Fair Limited. The beta of the Fair Limited is 0.75.
10. Ram buys 10,000 shares of X Ltd. at a price of ` 22 per share whose beta value is 1.5 and
sells 5,000 shares of A Ltd. at a price of ` 40 per share having a beta value of 2. He obtains
a complete hedge by Nifty futures at ` 1,000 each. He closes out his position at the closing
price of the next day when the share of X Ltd. dropped by 2%, share of A Ltd. appreciated
by 3% and Nifty futures dropped by 1.5%.
What is the overall profit/loss to Ram?
11. On January 1, 2013 an investor has a portfolio of 5 shares as given below:
Security Price No. of Shares Beta
A 349.30 5,000 1.15
B 480.50 7,000 0.40
C 593.52 8,000 0.90
D 734.70 10,000 0.95
E 824.85 2,000 0.85
The cost of capital to the investor is 10.5% per annum.

(i) The beta of his portfolio.
(ii) The theoretical value of the NIFTY futures for February 2013.
(iii) The number of contracts of NIFTY the investor needs to sell to get a full hedge until
February for his portfolio if the current value of NIFTY is 5900 and NIFTY fut ures
have a minimum trade lot requirement of 200 units. Assume that the futures are
trading at their fair value.
(iv) The number of future contracts the investor should trade if he desires to reduce the
beta of his portfolios to 0.6.
No. of days in a year be treated as 365.
Given: In (1.105) = 0.0998 and e (0.015858) = 1.01598
12. Details about portfolio of shares of an investor is as below:
Shares No. of shares (Iakh) Price per share Beta
A Ltd. 3.00 ` 500 1.40
B Ltd. 4.00 ` 750 1.20
C Ltd. 2.00 ` 250 1.60
The investor thinks that the risk of portfolio is very high and wants to reduce the portfolio
beta to 0.91. He is considering two below mentioned alternative strategies:
(i) Dispose off a part of his existing portfolio to acquire risk free securities, or
(ii) Take appropriate position on Nifty Futures which are currently traded at ` 8125 and
each Nifty points is worth `200.
(1) portfolio beta,
(2) the value of risk free securities to be acquired,
(3) the number of shares of each company to be disposed off,
(4) the number of Nifty contracts to be bought/sold; and
(5) the value of portfolio beta for 2% rise in Nifty.
13. On April 1, 2015, an investor has a portfolio consisting of eight securit ies as shown below:
Security Market Price No. of Shares Value
A 29.40 400 0.59
B 318.70 800 1.32
C 660.20 150 0.87
D 5.20 300 0.35
E 281.90 400 1.16
F 275.40 750 1.24
G 514.60 300 1.05
H 170.50 900 0.76
The cost of capital for the investor is 20% p.a. continuously compounded. The investor
fears a fall in the prices of the shares in the near future. Accordingly, he approaches you for
the advice to protect the interest of his portfolio.
You can make use of the following information:

(1) The current NIFTY value is 8500.
(2) NIFTY futures can be traded in units of 25 only.
(3) Futures for May are currently quoted at 8700 and Futures for June are being quoted
at 8850.
(i) the beta of his portfolio.
(ii) the theoretical value of the futures contract for contracts expiring in May and June.
Given (e0.03 =1.03045, e 0.04 = 1.04081, e 0.05 =1.05127)
(iii) the number of NIFTY contracts that he would have to sell if he desires to hedge until
June in each of the following cases:
(A) His total portfolio
(B) 50% of his portfolio
(C) 120% of his portfolio
14. Sensex futures are traded at a multiple of 50. Consider the following quotations of Sensex
futures in the 10 trading days during February, 2009:
Day High Low Closing
4-2-09 3306.4 3290.00 3296.50
5-2-09 3298.00 3262.50 3294.40
6-2-09 3256.20 3227.00 3230.40
7-2-09 3233.00 3201.50 3212.30
10-2-09 3281.50 3256.00 3267.50
11-2-09 3283.50 3260.00 3263.80
12-2-09 3315.00 3286.30 3292.00
14-2-09 3315.00 3257.10 3309.30
17-2-09 3278.00 3249.50 3257.80
18-2-09 3118.00 3091.40 3102.60
Abshishek bought one sensex futures contract on February, 04. The average daily absolute
change in the value of contract is ` 10,000 and standard deviation of these changes is
` 2,000. The maintenance margin is 75% of initial margin.
You are required to determine the daily balances in the margin account and payment on
margin calls, if any.
15. Mr. A purchased a 3 month call option for 100 shares in XYZ Ltd. at a premium of ` 30 per
share, with an exercise price of ` 550. He also purchased a 3 month put option for 100
shares of the same company at a premium of ` 5 per share with an exercise price of ` 450.
The market price of the share on the date of Mr. A’s purchase of options, is ` 500.
Calculate the profit or loss that Mr. A would make assuming that the market price falls to `
350 at the end of 3 months.
16. The market received rumour about ABC corporation’s tie-up with a multinational company.
This has induced the market price to move up. If the rumour is false, the ABC corporation
stock price will probably fall dramatically. To protect from this an investor has bought the
call and put options.
He purchased one 3 months call with a striking price of ` 42 for ` 2 premium, and paid Re.1
per share premium for a 3 months put with a striking price of ` 40.
(i) Determine the Investor’s position if the tie up offer bids the price of ABC
Corporation’s stock up to ` 43 in 3 months.
(ii) Determine the Investor’s ending position, if the tie up programme fails and the price
of the stocks falls to ` 36 in 3 months.
17. Equity share of PQR Ltd. is presently quoted at ` 320. The Market Price of the share after 6
months has the following probability distribution:
Market Price ` 180 260 280 320 400
Probability 0.1 0.2 0.5 0.1 0.1
A put option with a strike price of ` 300 can be written.
You are required to find out expected value of option at maturity (i.e. 6 months)
18. You as an investor had purchased a 4 month call option on the equity shares of X Ltd. of `
10, of which the current market price is ` 132 and the exercise price ` 150. You expect the
price to range between ` 120 to ` 190. The expected share price of X Ltd. and related
probability is given below:
Expected Price (`) 120 140 160 180 190
Probability .05 .20 .50 .10 .15
Compute the following:

(i) Expected Share price at the end of 4 months.
(ii) Value of Call Option at the end of 4 months, if the exercise price prevails.
(iii) In case the option is held to its maturity, what will be the expected value of the call
option?
19. Mr. X established the following strategy on the Delta Corporation’s stock :
(1) Purchased one 3-month call option with a premium of ` 30 and an exercise price of
` 550.
(2) Purchased one 3-month put option with a premium of ` 5 and an exercise price of
` 450.
Delta Corporation’s stock is currently selling at ` 500. Determine profit or loss, if the price
of Delta Corporation’s :
(i) remains at ` 500 after 3 months.
(ii) falls at ` 350 after 3 months.
(iii) rises to ` 600.
Assume the size option is 100 shares of Delta Corporation.
20. The equity share of VCC Ltd. is quoted at ` 210. A 3-month call option is available at a
premium of ` 6 per share and a 3-month put option is available at a premium of ` 5 per
share. Ascertain the net payoffs to the option holder of a call option and a put option
separately.
(i) the strike price in both cases in ` 220; and
(ii) the share price on the exercise day is ` 200,210,220,230,240.
Also indicate the price range at which the call and the put options may be gainfully
exercised.
21. Sumana wanted to buy shares of ElL which has a range of ` 411 to ` 592 a month later.
The present price per share is ` 421. Her broker informs her that the price of this share can
sore up to ` 522 within a month or so, so that she should buy a one-month CALL of ElL. In
order to be prudent in buying the call, the share price should be more than or at least ` 522
the assurance of which could not be given by her broker.
Though she understands the uncertainty of the market, she wants to know the probability of
attaining the share price ` 592 so that buying of a one-month CALL of EIL at the execution
price of ` 522 is justified. Advice her. Take the risk-free interest to be 3.60% and e 0.036
= 1.037.
22. Mr. Dayal is interested in purchasing equity shares of ABC Ltd. which are currently selling
at ` 600 each. He expects that price of share may go upto ` 780 or may go down to ` 480
in three months. The chances of occurring such variations are 60% and 40% res pectively. A
call option on the shares of ABC Ltd. can be exercised at the end of three months with a
strike price of ` 630.
(i) What combination of share and option should Mr. Dayal select if he wants a perfect
hedge?
(ii) What should be the value of option today (the risk free rate is 10% p.a.)?
(iii) What is the expected rate of return on the option?
23. Consider a two-year call option with a strike price of ` 50 on a stock the current price of
which is also ` 50. Assume that there are two-time periods of one year and in each year the
stock price can move up or down by equal percentage of 20%. The risk-free interest rate is
6%. Using binominal option model, calculate the probability of price moving up and down.
Also draw a two-step binomial tree showing prices and payoffs at each node.
24. The current market price of an equity share of Penchant Ltd is `r420. Within a period of 3
months, the maximum and minimum price of it is expected to be ` 500 and ` 400
respectively. If the risk free rate of interest be 8% p.a., what should be the value of a 3
months Call option under the “Risk Neutral” method at the strike rate of ` 450?
Given e0.02 = 1.0202
25. From the following data for certain stock, find the value of a call option:
Price of stock now = ` 80
Exercise price = ` 75
Standard deviation of continuously compounded = 0.40
annual return
Maturity period = 6 months
Annual interest rate = 12%
Given
Number of S.D. from Mean, (z) Area of the left or right (one tail)
0.25 0.4013
0.30 0.3821
0.55 0.2912
0.60 0.2743
e 0.12x0.5 = 1.062
In 1.0667 = 0.0646
ANSWERS/ SOLUTIONS

1. Calculation of spot price
The formula for calculating forward price is:
r nt
A = P (1+ )
n
Where A = Forward price
P = Spot Price
r = rate of interest
n = no. of compounding
t = time
Using the above formula,
208.18 = P (1 + 0.08/12) 6
Or 208.18 = P x 1.0409
P = 208.18/1.0409 = 200
Hence, the spot price should be ` 200.
2. Anand Ltd
(i) Calculation of theoretical minimum price of a 6 months forward contract-
Theoretical minimum price = ` 1,800 + (` 1,800 x 12/100 x 6/12) = ` 1,908
(ii) Arbitrage Opportunity-
The arbitrageur can borrow money @ 12 % for 6 months and buy the shares at `
1,800. At the same time he can sell the shares in the futures market at ` 1,950. On
the expiry date 6 months later, he could deliver the share and collect ` 1,950 pay off
` 1,908 and record a profit of ` 42 (` 1,950 – ` 1,908)
3. The duration of future contract is 4 months. The average yield during this period will be:
3% + 3% + 4% + 3%
= 3.25%
4
As per Cost to Carry model the future price will be
F = Se(rf −D )t
Where S = Spot Price

rf = Risk Free interest
D = Dividend Yield
t = Time Period
Accordingly, future price will be
= ` 2,200 e( 0.08- 0.0325)4 /12 = ` 2,200 e0.01583
= ` 2,200 х 1.01593 = ` 2235.05
4. Future’s Price = Spot + cost of carry – Dividend
F = 220 + 220 × 0.15 × 0.25 – 0.25** × 10 = 225.75
** Entire 25% dividend is payable before expiry, which is `2.50.
Thus we see that futures price by calculation is `225.75 which is quoted at `230 in the
exchange.
(i) Analysis:
Fair value of Futures less than Actual futures Price:
Futures Overvalued Hence it is advised to sell. Also do Arbitraging by buying stock i n the
cash market.
Step I
He will buy PQR Stock at `220 by borrowing at 15% for 3 months. Therefore, his outflows
are:
Cost of Stock 220.00
Add: Interest @ 15 % for 3 months i.e. 0.25 years (220 × 0.15 × 0.25) 8.25
Total Outflows (A) 228.25
Step II
He will sell March 2000 futures at `230. Meanwhile he would receive dividend for his stock.
Hence his inflows are 230.00
Sale proceeds of March 2000 futures 2.50
Total inflows (B) 232.50
Inflow – Outflow = Profit earned by Arbitrageur
= 232.50 – 228.25 = 4.25
4
5. (i) Current future price of the index = 5000 + 5000 (0.09-0.06) = 5000+ 50= 5,050
12
 Price of the future contract = ` 50 х 5,050 = ` 2,52,500
1010000
(ii) Hedge ratio = 1.5 = 6 contracts
252500
Index after there months turns out to be 4500
1
Future price will be = 4500 + 4500 (0.09-0.06) × = 4,511.25
12
Therefore, Gain from the short futures position is = 6 х (5050 – 4511.25) х 50
= `1,61,625
Note: Alternatively we can also use daily compounding (exponential) formula.
6. The appropriate value of the 3 months futures contract is –
Fo = ` 300 (1.008) 3 = ` 307.26
Since the futures price exceeds its appropriate value it pays to do the following:-
Action Initial Cash flow at
Cash flow time T (3 months)
Borrow ` 300 now and repay with interest + ` 300 - ` 300 (1.008)3 =- ` 307.26
after 3 months
Buy a share - ` 300 ST
Sell a futures contract (Fo = 312/-) 0 ` 312 – ST
Total `0 ` 4.74
Such an action would produce a risk less profit of ` 4.74.

7. Number of index future to be sold by the Fund Manager is:
1.1 90,00,00,000
= 4,605
4,300  50
Justification of the answer:
11
Loss in the value of the portfolio if the index falls by 10% is ` x90 Crore = ` 9.90 Crore.
100
0.1 4,300  50  4,605
Gain by short covering of index future is: = 9.90 Crore
1,00,00,000
This justifies the answer. Further, cash is not a part of the portfolio.
8. (i) Current Portfolio Beta

Current Beta for share portfolio = 1.6
Beta for cash =0
Current portfolio beta = 0.85 x 1.6 + 0 x 0.15 = 1.36
(ii) Portfolio beta after 3 months:
Change in value of portfolio of share
Beta for portfolio of shares =
Change in value of market portfolio (Index)
0.032
1.6 =
Change in value of market portfolio (Index)
Change in value of market portfolio (Index) = (0.032 / 1.6) x 100 = 2%

Position taken on 100 lakh Nifty futures : Long
Value of index after 3 months = ` 100 lakh x (1.00 - 0.02)
= ` 98 lakh
Mark-to-market paid = ` 2 lakh
Cash balance after payment of mark-to-market = ` 13 lakh
Value of portfolio after 3 months = `85 lakh x (1 - 0.032) + `13 lakh
= `95.28 lakh
`100 lakh - `95.28 lakh
Change in value of portfolio = = 4.72%
`100 lakh
Portfolio beta = 0.0472/0.02 = 2.36
9.
Sl. No. Company Name Trend Amount (`) Beta (`) Position
(1) (2) (3) (4) (5) (6) (7)
[(4) x (5)]
(i) Right Ltd. Rise 50 lakh 1.25 62,50,000 Short
(ii) Wrong Ltd. Depreciate 25 lakh 0.90 22,50,000 Long
(iii) Fair Ltd. Stagnant 20 lakh 0.75 15,00,000 Long
25,00,000 Short
10. No. of the Future Contract to be obtained to get a complete hedge

10000 ×`22 × 1.5 - 5000 × ` 40 × 2
=
`1000
`3,30,000 - ` 4,00,000
= = 70 contracts
`1000
Thus, by purchasing 70 Nifty future contracts to be long to obtain a complete hedge.
Cash Outlay
= 10000 x ` 22 – 5000 x ` 40 + 70 x ` 1,000
= ` 2,20,000 – ` 2,00,000 + ` 70,000 = ` 90,000
Cash Inflow at Close Out
= 10000 x ` 22 x 0.98 – 5000 x ` 40 x 1.03 + 70 x ` 1,000 x 0.985
= ` 2,15,600 – ` 2,06,000 + ` 68,950 = ` 78,550
Gain/ Loss
= ` 78,550 – ` 90,000 = - ` 11,450 (Loss)
11. (i) Calculation of Portfolio Beta
Security Price No. of Value Weightage Beta Weighted
of the shares wi Βi Beta
Stock
A 349.30 5,000 17,46,500 0.093 1.15 0.107
B 480.50 7,000 33,63,500 0.178 0.40 0.071
C 593.52 8,000 47,48,160 0.252 0.90 0.227
D 734.70 10,000 73,47,000 0.390 0.95 0.370
E 824.85 2,000 16,49,700 0.087 0.85 0.074
1,88,54,860 0.849
Portfolio Beta = 0.849
(ii) Calculation of Theoretical Value of Future Contract
Cost of Capital = 10.5% p.a. Accordingly, the Continuously Compounded Rate of
Interest ln (1.105) = 0.0998
For February 2013 contract, t= 58/365= 0.1589
Further F= Sert
F= ` 5,900e(0.0998)(0.1589)
F= ` 5,900e0.015858
F= ` 5,900X1.01598 = ` 5,994.28
Alternatively, it can also be taken as follows:
= ` 5900 e0.105×58/365
= ` 5900 e0.01668
= ` 5900 x 1.01682 = ` 5,999.24
(iii) When total portfolio is to be hedged:
Value of Spot Position requiring hedging
=  Portfolio Beta
Value of Future Contract
1,88,54,860
=  0.849io= 13.35 contracts say 13 or 14 contracts
5994.28  200
(iv) When total portfolio beta is to be reduced to 0.6:
P(P − β P' )
Number of Contracts to be sold = o
F
1,88,54,860 (0.849 - 0.600)
= io= 3.92 contracts say 4 contracts
5994.28  200
12.
Shares No. of Market × (2) % to ß (x) wx
shares Price of (` lakhs) total (w)
(lakhs) (1) Per Share
(2)
A Ltd. 3.00 500.00 1500.00 0.30 1.40 0.42
B Ltd. 4.00 750.00 3000.00 0.60 1.20 0.72
C Ltd. 2.00 250.00 500.00 0.10 1.60 0.16
5000.00 1.00 1.30
(1) Portfolio beta 1.30

(2) Required Beta 0.91
Let the proportion of risk free securities for target beta 0.91 = p
0.91 = 0 × p + 1.30 (1 – p)
p = 0.30 i.e. 30%
Shares to be disposed off to reduce beta (5000 × 30%) ` 1,500 lakh and Risk Free
securities to be acquired.
(3) Number of shares of each company to be disposed off

Shares % to total Proportionate Market Price No. of Shares
(w) Amount (` lakhs) Per Share (Lakh)
A Ltd. 0.30 450.00 500.00 0.90
B Ltd. 0.60 900.00 750.00 1.20
C Ltd. 0.10 150.00 250.00 0.60
(4) Number of Nifty Contract to be sold

(1.30-0.91) × 5000 lakh
= 120 contracts
8,125 × 200
(5) 2% rises in Nifty is accompanied by 2% x 1.30 i.e. 2.6% rise for portfolio of shares
` Lakh
Current Value of Portfolio of Shares 5000
Value of Portfolio after rise 5130
Mark-to-Market Margin paid (8125 × 0.020 × ` 200 × 120) 39
Value of the portfolio after rise of Nifty 5091
% change in value of portfolio (5091 – 5000)/ 5000 1.82%
% rise in the value of Nifty 2%
Beta 0.91
13. (i) Beta of the Portfolio
Security Market No. of Value β Value x β
Price Shares
A 29.40 400 11760 0.59 6938.40
B 318.70 800 254960 1.32 336547.20
C 660.20 150 99030 0.87 86156.10
D 5.20 300 1560 0.35 546.00
E 281.90 400 112760 1.16 130801.60
F 275.40 750 206550 1.24 256122.00
G 514.60 300 154380 1.05 162099.00
H 170.50 900 153450 0.76 116622.00
994450 1095832.30
10,95,832.30
Portfolio Beta = = 1.102
9,94,450
(ii) Theoretical Value of Future Contract Expiring in May and June

F = Sert
FMay= 8500 x e0.20 x (2/12) = 8500 x e0.0333
e0.0333 shall be computed using Interpolation Formula as follows:
e0.03 = 1.03045
e0.04 = 1.04081
e0.01 = 0.01036
e0.0033 = 0.00342
e0.0067 = 0.00694
e0.0333 = 1.03045 + 0.00342 = 1.03387 or 1.04081 – 0.00694 = 1.03387

According the price of the May Contract
8500 X 1.03387 = ` 8788
Price of the June Contract
FMay= 8500 x e0.20 x (3/12) = 8500 x e0.05= 8500 x 1.05127 = 8935.80
(iii) No. of NIFTY Contracts required to sell to hedge until June
Value of Position to be hedged
= 
Value of Future Contract
(A) Total portfolio
994450
 1.102 = 4.953 say 5 contracts
8850  25
(B) 50% of Portfolio
994450  0.50
 1.102 = 2.47 say 3 contracts
8850  25
(C) 120% of Portfolio
994450  1.20
 1.102 = 5.94 say 6 contracts
8850  25
14. Initial Margin = µ + 3 
Where µ = Daily Absolute Change
 = Standard Deviation
Accordingly
Initial Margin = ` 10,000 + ` 6,000 = ` 16,000
Maintenance margin = ` 16,000 x 0.75 = ` 12,000
Day Changes in future Values (`) Margin A/c (`) Call Money (`)
4/2/09 - 16000 -
5/2/09 50 x (3294.40 - 3296.50) = -105 15895 -
6/2/09 50 x (3230.40 - 3294.40)= -3200 12695 -
7/2/09 50 x (3212.30 - 3230.40)= -905 16000 4210
10/2/09 50x(3267.50 - 3212.30)= 2760 18760 -
11/2/09 50x(3263.80 - 3267.50)= -185 18575 -
12/2/09 50x(3292 - 3263.80) =1410 19985 -
14/2/09 50x(3309.30 - 3292)=865 20850 -
17/2/09 50x(3257.80 - 3309.30)=-2575 18275 -
18/2/09 50x(3102.60 - 3257.80)=-7760 16000 5485
15. Since the market price at the end of 3 months falls to ` 350 which is below the exercise
price under the call option, the call option will not be exercised. Only put option becomes
viable.
`
The gain will be:
Gain per share (`450 – ` 350) 100
Total gain per 100 shares 10,000
Cost or premium paid (` 30 x 100) + (` 5 x 100) 3,500
Net gain 6,500
16. Cost of Call and Put Options
= (` 2 per share) x (100 share call) + (` 1 per share) x (100 share put)
= ` 2 x 100 + 1 x 100
= ` 300
(i) Price increases to `43. Since the market price is higher than the strike price of the
call, the investor will exercise it.
Ending position = (- ` 300 cost of 2 option) + (` 1 per share gain on call) x 100
= - ` 300 + 100
Net Loss = - ` 200
(ii) The price of the stock falls to `36. Since the market price is lower than the strike
price, the investor may not exercise the call option.
Ending Position = (- `300 cost of 2 options) + (`4 per stock gain on put) x 100
= - `300 + 400
Gain = `100
17. Expected Value of Option
(300 – 180) X 0.1 12
(300 – 260) X 0.2 8
(300 – 280) X 0.5 10
(300 – 320) X 0.1 Not Exercised*
30
* If the strike price goes beyond ` 300, option is not exercised at all.
In case of Put option, since Share price is greater than strike price Option Value would be
zero.
18. (i) Expected Share Price
= `120X 0.05 + `140X 0.20 + `160X 0.50 + `180X 0.10 + `190X 0.15
= `6 + `28 + `80 + `18 + `28.50 = `160.50
(ii) Value of Call Option
= `150 - `150 = Nil
(iii) If the option is held till maturity the expected Value of Call Option
Expected price (X) Value of call (C) Probability (P) CP
` 120 0 0.05 0
` 140 0 0.20 0
` 160 ` 10 0.50 `5
` 180 ` 30 0.10 `3
` 190 ` 40 0.15 `6
Total ` 14
Alternatively, it can also be calculated as follows:

Expected Value of Option
(160 – 150) X 0.5 5
(180 – 150) X 0.1 3
(190 – 150) X 0.15 6
14
* If the strike price goes below ` 150, option is not exercised at all.
19. (i) Total premium paid on purchasing a call and put option
= (`30 per share × 100) + (`5 per share × 100).
= 3,000 + 500 = `3,500
In this case, X exercises neither the call option nor the put option as both will result
in a loss for him.
Ending value = - `3,500 + zero gain = - `3,500
i.e Net loss = `3,500
(ii) Since the price of the stock is below the exercise price of the call, the call will not be
exercised. Only put is valuable and is exercised.
Total premium paid = `3,500
Ending value = – `3,500 + `[(450 – 350) × 100] = – `3,500 + `10,000 = `6,500
 Net gain = `6,500
(iii) In this situation, the put is worthless, since the price of the stock exceeds the put’s
exercise price. Only call option is valuable and is exercised.
Total premium paid = `3,500
Ending value = -3,500 +[(600 – 550) × 100]
Net Gain = -3,500 + 5,000 = `1,500
20. Net payoff for the holder of the call option
(`)
Share price on exercise day 200 210 220 230 240
Option exercise No No No Yes Yes
Outflow (Strike price) Nil Nil Nil 220 220
Out flow (premium) 6 6 6 6 6
Total Outflow 6 6 6 226 226
Less inflow (Sales proceeds) - - - 230 240
Net payoff -6 -6 -6 4 14
Net payoff for the holder of the put option

(`)
Share price on exercise day 200 210 220 230 240
Option exercise Yes Yes No No No
Inflow (strike price) 220 220 Nil Nil Nil
Less outflow (purchase price) 200 210 - - -
Less outflow (premium) 5 5 5 5 5
Net Payoff 15 5 -5 -5 -5
The call option can be exercised gainfully for any price above `226 (`220 + `6) and put
option for any price below `215 (`220 - `5).
e rt − d
21. p=
u−d
ert = e0.036
d = 411/421 = 0.976
u = 592/421 = 1.406
e 0.036 − 0.976 1.037 − 0.976 0.061
p= = = = 0.1418
1.406 − 0.976 0.43 0.43
Thus probability of rise in price 0.1418
22. (i) To compute perfect hedge we shall compute Hedge Ratio (Δ) as follows:
C1 − C2 150 − 0 150
Δ= = = = 0.50
S1 − S2 780 − 480 300
Mr. Dayal should purchase 0.50 share for every 1 call option.
(ii) Value of Option today

If price of share comes out to be `780 then value of purchased share will be:
Sale Proceeds of Investment (0.50 x ` 780) ` 390
Loss on account of Short Position (` 780 – ` 630) ` 150
` 240
If price of share comes out to be ` 480 then value of purchased share will be:
Sale Proceeds of Investment (0.50 x ` 480) ` 240
Accordingly, Premium say P shall be computed as follows:
(` 300 – P) 1.025 = ` 240
P = `65.85
(iii) Expected Return on the Option
Expected Option Value = (` 780 – ` 630) × 0.60 + ` 0 × 0.40 = ` 90
90 − 65.85
Expected Rate of Return =  100 = 36.67%
65.85
23. Stock prices in the two step Binominal tree
Using the single period model, the probability of price increase is

R − d 1.06 − 0.80 0.26
P= = = = 0.65
u−d 1.20 − 0.80 0.40
therefore the p of price decrease = 1-0.65 = 0.35
The two step Binominal tree showing price and pay off
The value of an American call option at nodes D, E and F will be equal to the value of
European option at these nodes and accordingly the call values at nodes D, E and F will be
22, 0 and 0 using the single period binomial model the value of call option at node B is
Cup + Cd(1 − p) 22  0.65 + 0  0.35
C= = = 13.49
R 1.06
The value of option at node ‘A’ is
13.49  0.65 + 0  0.35
= 8.272
1.06
24. Let the probability of attaining the maximum price be p
(500 - 420) х p+(400 - 420) х (1-p) = 420 х (e0.02-1)
or, 80p - 20(1 - p) = 420 х 0.0202
or, 80p – 20 + 20p = 8.48
or, 100p = 28.48
p = 0.2848
0.2848x(500 − 450) 0.2848x50 + 0.7152  0
The value of Call Option in ` = = =13.96
1.0202 1.0202
25. Applying the Black Scholes Formula,
Value of the Call option now:
The Formula C = SN(d1 ) − Ke ( −rt) N(d2 )
In (S/K) + (r + σ 2 / 2)t
d1 =
σ t
d2 = d1 - σ t
Where,
C = Theoretical call premium
S = Current stock price
t = time until option expiration
K = option striking price
r = risk-free interest rate
N = Cumulative standard normal distribution
e = exponential term
 = Standard deviation of continuously compounded annual return.
In = natural logarithim
In (1.0667) + (12% + 0.08)0.5
d1 =
0.40 0.5
= 0.0646 + (0.2)0.5
0.40  0.7071
0.1646
=
0.2828
= 0.5820
d2 = 0.5820 – 0.2828 = 0.2992
N(d1) = N (0.5820)
N(d2) = N (0.2992)
Price = SN(d1 ) − Ke ( −rt) N(d2 )
= 80 x N(d1) – (75/1.062) x N(d2)

Value of option
75
= 80 N(d1) -  N(d2 )
1.062
N(d1) = N (0.5820) = 0.7197
N(d2) = N(0.2992) = 0.6176
75
Price = 80 x 0.7197 –  0.6176
1.062
= 57.57 – 70.62 x 0.6176
= 57.57 – 43.61
= `13.96
Teaching Notes:
Students may please note following important point:
Values of N(d1) and N(d2) have been computed by interpolating the values of areas under
respective numbers of SD from Mean (Z) given in the question.
It may also be possible that in question paper areas under Z may be mentioned otherwise e.g.
Cumulative Area or Area under Two tails. In such situation the areas of the respective Zs given in
the question will be as follows:
Cumulative Area
Number of S.D. from Mean, (z) Cumulative Area
0.25 0.5987
0.30 0.6179
0.55 0.7088
0.60 0.7257
Two tail area
Number of S.D. from Mean, (z) Area of the left and right (two tail)
0.25 0.8026
0.30 0.7642
0.55 0.5823
0.60 0.5485
9
FOREIGN EXCHANGE EXPOSURE

AND RISK MANAGEMENT
LEARNING OUTCOMES
❑ Exchange rate determination
❑ Foreign currency market
❑ Management of transaction, translation and economic exposures
❑ Hedging currency risk
❑ Foreign exchange derivatives – Forward, futures, options and
swaps
1. INTRODUCTION
Coupled with globalisation of business, the raising of capital from the international capital markets
has assumed significant proportion during the recent years. The volume of finance raised from
international capital market is steadily increasing over a period of years, across the national
boundaries. Every day new institutions are emerging on the international financial scenario and
introducing new derivative financial instruments (products) to cater to the requirements of
multinational organisations and the foreign investors.
To accommodate the underlying demands of investors and capital raisers, financial institutions and
instruments have also changed dramatically. Financial deregulation, first in the United States and
then in Europe and Asia, has prompted increased integration of world financial markets. As a
result of the rapidly changing scenario, the finance manager today has to be global in his
approach.
In consonance with these remarkable changes, the Government of India has also opened Indian
economy to foreign investments and has taken a number of bold and drastic me asures to globalise
the Indian economy. Various fiscal, trade and industrial policy decisions have been taken and new
avenues provided to foreign investors like Foreign Institutional Investors ( FII's) and NRI's etc., for
investment especially in infrastructural sectors like power and telecommunication etc.
The basic principles of financial management i.e., efficient allocation of resources and raising of
funds on most favourable terms and conditions etc. are the same, both for domestic and
international enterprises. However, the difference lies in the environment in which these multi-
national organisations function. The environment relates to political risks, Government's tax and
investment policies, foreign exchange risks and sources of finance etc. These are some of the
crucial issues which need to be considered in the effective management of international financial
transactions and investment decisions.
Under the changing circumstances as outlined above, a finance manager, naturally cannot just be
a silent spectator and wait and watch the developments. He has to search for "best price" in a
global market place (environment) through various tools and techniques. Sometimes he uses
currency and other hedges to optimise the utilisation of financial resources at his command.
However, the problems to be faced by him in the perspective of financial management of the
multinational organisations are slightly more complex than those of domestic organisations. While
the concepts developed earlier in the previous chapters are also applicable here, the environment
in which decisions are made in respect of international financial management is different and it
forms the subject matter of this chapter for discussion. In this chapter we shall describe how a
finance manager can protect his organisation from the vagaries of international financial
transactions.
2. NOSTRO, VOSTRO AND LORO ACCOUNTS

In interbank transactions, foreign exchange is transferred from one account to another account
and from one centre to another centre. Therefore, the banks maintain three types of current
accounts in order to facilitate quick transfer of funds in different currencies. These accounts are
Nostro, Vostro and Loro accounts meaning “our”, “your” and “their”. A bank’s foreign currency
account maintained by the bank in a foreign country and in the home currency of that country is
known as Nostro Account or “our account with you”. For example, An Indian bank’s Swiss franc
account with a bank in Switzerland. Vostro account is the local currency account maintained by a
foreign bank/branch. It is also called “your account with us”. For example, Indian rupee account
maintained by a bank in Switzerland with a bank in India. The Loro account is an account wherein
a bank remits funds in foreign currency to another bank for credit to an account of a third bank.
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.3
2.1 Exchange Position

It is referred to total of purchases or sale of commitment of a bank to purchase or sale foreign
exchange whether actual delivery has taken place or not. In other words, all transactions for which
bank has agreed with counter party are entered into exchange position on the date of the contract.
2.2 Cash Position
it is outstanding balance (debit or credit) in bank’s Nostro account. Since all foreign exchange
dealings of bank are routed through Nostro account it is credited for all purchases and debited for
sale by bank.
It should however be noted that all dealings whether delivery has taken place or not effects the
Exchange Position but Cash Position is effected only when actual delivery has taken place.
Therefore, all transactions effecting Cash position will affect Exchange Position not vice versa.
Illustration 1
Suppose you are a dealer of ABC Bank and on 20.10.2014 you found that balance in your Nostro
account with XYZ Bank in London is £65,000 and you had overbought £35,000. During the day
following transaction have taken place:
£
DD purchased 12,500
Purchased a Bill on London 40,000
Sold forward TT 30,000
Forward purchase contract cancelled 15,000
Remitted by TT 37,500
Draft on London cancelled 15,000
What steps would you take, if you are required to maintain a credit Balance of £7,500 in the Nostro
A/c and keep as overbought position on £7,500?
Solution
Exchange Position:
Particulars Purchase £ Sale £
Opening Balance Overbought 35,000 —
DD Purchased 12,500 —
Purchased a Bill on London 40,000 —
Sold forward TT — 30,000
Forward purchase contract cancelled — 15,000
TT Remittance 37,500
Draft on London cancelled 15,000 —
1,02,500 82,500
Closing Balance Overbougt — 20,000
1,02,500 1,02,500
Cash Position (Nostro A/c)

Credit £ Debit £
Opening balance credit 65,000 —
TT Remittance — 37,500
65,000 37,500
Closing balance (credit) — 27,500
65,000 65,000
To maintain Cash Balance in Nostro Account at £7,500 you have to sell £20,000 in Spot which will
bring Overbought exchange position to Nil. Since bank require Overbought position of £7 ,500 it
has to buy the same in forward market.
3. EXCHANGE RATE QUOTATION

3.1 American Term and European Term
Quotes in American terms are the rates quoted in amounts of U.S. dollar per unit of foreign
currency. While rates quoted in amounts of foreign currency per U.S. dollar are known as quotes in
European terms.
For example, U.S. dollar 0.2 per unit of Indian rupee is an American quote while INR 44.92 per unit
of U.S. dollar is a European quote.
Most foreign currencies in the world are quoted in terms of the number of units of foreign currency
needed to buy one U.S. dollar i.e. the European term.
3.2 Direct and Indirect Quote
As indicated earlier, a currency quotation is the price of a currency in terms of another currency.
For example, $1 = ` 48.00, means that one dollar can be exchanged for ` 48.00. Alternatively, we
may pay ` 48.00 to buy one dollar. A foreign exchange quotation can be either a direct quotation
and or an indirect quotation, depending upon the home currency of the person concerned.
A direct quote is the home currency price of one unit foreign currency. Thus, in the aforesaid
example, the quote $1 =` 48.00 is a direct-quote for an Indian.
An indirect quote is the foreign currency price of one unit of the home currency. The quote
Re.1 =$0.0208 is an indirect quote for an Indian. ($1/` 48.00 =$0.0208 approximately)
Direct and indirect quotes are reciprocals of each other, which can be mathematically expressed
as follows.
Direct quote = 1/indirect quote and vice versa
The following table is an extract from the Bloomberg website showing the Foreign Exchange Cross
rates prevailing on 14/09/2012.
USD CNY JPY HKD INR
KRW SGD EUR
USD – 0.1583 0.0128 0.129 0.0184
0.0009 0.8197 1.3089
CNY 6.3162 – 0.0809 0.8147 0.1161
0.0057 5.177 8.2667
JPY 78.08 12.362 – 10.072 1.435
0.0701 64 102.17
HKD 7.7526 1.2274 0.0993 – 0.143
0.0069 6.3546 10.148
INR 54.405 8.613 0.6955 7.005 – 0.0488 44.505 71.067
KRW 1,114.65 176.5476 14.2965 143.9908 20.4965 – 914.8582 1,459.05
SGD 1.2202 0.1932 0.0156 0.1574 0.0224 0.0011 – 1.5961
EUR 0.7642 0.121 0.0098 0.0986 0.014 0.0007 0.6263 –
Source :http://www.bloomberg.com/markets/currencies/cross-rates/
Students will notice that the rates given in the rows are direct quotes for ea ch of the currencies
listed in the first column and the rates given in the columns are the indirect quotes for the
currencies listed in the first row. Students can also verify that in every case above .
3.3 Bid, Offer and Spread
A foreign exchange quotes are two-way quotes, expressed as a 'bid' and an offer' (or ask) price.
Bid is the price at which the dealer is willing to buy another currency. The offer is the rate at which
he is willing to sell another currency. Thus a bid in one currency is simultaneously an offer in
another currency. For example, a dealer may quote Indian rupees as `48.80 - 48.90 vis-a-vis
dollar. That means that he is willing to buy dollars at `48.80/$ (sell rupees and buy dollars), while
he will sell dollar at ` 48.90/$ (buy rupees and sell dollars). The difference between the bid and
the offer is called the spread. The offer is always higher than the bid as inter -bank dealers make
money by buying at the bid and selling at the offer.
Bid - Offer
% Spread =  100
Bid
It must be clearly understood that while a dealer buys a currency, he at the same time is selling
another currency. When a dealer wants to buy a currency, he/she will ask the other dealer a quote
for say a million dollars. The second dealer does not know whether the first dealer is interested in
buying or selling one million dollars. The second dealer would then give a two-way quote (a
bid/offer quote). When the first dealer is happy with the ‘ask’ price given by the second dealer,
he/she would convey “ONE MINE”, which means “I am buying one million dollars from you”. If the
first dealer had actually wanted to sell one million dollars and had asked a quote and he is happy
with the ‘bid’ price given by the second dealer, he/she would convey “ONE YOURS”, whic h means
“I am selling one million dollars to you”.
3.4 Cross Rates
It is the exchange rate which is expressed by a pair of currency in which none of the currencies is
the official currency of the country in which it is quoted. For example, if the currency exchange rate
between a Canadian dollar and a British pound is quoted in Indian newspapers, then this would be
called a cross rate since none of the currencies of this pair is of Indian rupee.
Broadly, it can be stated that the exchange rates expressed by any currency pair that does not
involve the U.S. dollar are called cross rates. This means that the exchange rate of the currency
pair of Canadian dollar and British pound will be called a cross rate irrespective of the country in
which it is being quoted as it does not have U.S. dollar as one of the currencies.
3.5 Pips
This is another technical term used in the market. PIP is the Price Interest Point. It is the smallest
unit by which a currency quotation can change. E.g., USD/INR quoted to a customer is INR 61.75.
The minimum value this rate can change is either INR 61.74 or INR 61.76. In other words, for
USD/INR quote, the pip value is0.01. Pip in foreign currency quotation is similar to the tick size in
share quotations. However, in Indian interbank market, USD-INR rate is quoted upto 4 decimal
point. Hence minimum value change will be to the tune of 0.0001. Spot EUR/USD is quoted at a
bid price of 1.0213 and an ask price of 1.0219. The difference is USD 0.0006 equal to 6 “pips”.
3.6 Forward exchange rate quotation
Forward contract or outright forward contractor merely outright is an agreement between two
counterparts to exchange currencies on a future date at a rate fixed in the contract. Ideally, the
way in which exchange rate for a forward date [forward exchange rate] is quoted should be the
same as that for spot date e.g. if the spot rate is 61.53/54, then the [say six months] forward rate
quoting should look like say 61.93/98. However, the market convention is different. Forward rate is
not quoted as so and so exchange rate like this but always quoted with spot rate and the forward
margin separately. In other words, forward quote is not a foreign exchange rate quotation but is
quoted as a difference between spot & forward rates.
The reader or user has to calculate the forward applicable rate by loading the forward margin into
the spot rate. Thus e.g. in the above case, the foreign exchange dealer will quote the six month
forward rate as 40/44. He will even presume that the ongoing spot rate is known to the
counterparty and may not even mention. Even if he were to mention, he will mention only 53/54,
because the ‘big figure’ [in this case, “61”] is supposed to be known to the counterparty without
ambiguity. Since the rate fluctuation is very high, the dealer has no time to quote rates in very
detailed English sentences and these conventions have come into practice! The numbers 40 & 44
are arrived at as the differential between 61.93 – 61.53 and 61.98 – 62.54 respectively. These
numbers 40 & 44 are called forward margins representing the factor by which the forward rate is
different from the spot rate i.e. the margin to be ‘loaded’ onto the spot rate. Though looks silly, it is
worth reiterating that this margin is not the profit margin of the trader!
If the price on a future date is higher, then the currency is said to be at forward premium and then
the number represents the forward premium for that forward period. If the price on a future date is
lower, then the currency is said to be at forward discount and then the number represents the
forward discount for that forward period. In the above example, US dollar is at a premium and the
forward premium of USD for six months is 40/44 paise for buying and selling rate respectively in
the interbank market. Generally, the margin is quoted in annualized percentage terms. E.g. in this
case, extrapolating the premium of six months to twelve months, it can be said that US dollar is
likely to have a premium of 80 paise per year [40 paise per six months X 2] which mea ns on a
base rate of 61.53, the annualized premium [=0.8*2*100/61.53] is 2.60% p.a. In market parlance,
forward premium is quoted in percentage terms and this is the basis of calculation. Actually, the
forward market in foreign exchange is an interest rate market and is not a foreign exchange
market. Because it compares interest rate of one currency with that of another over a period of
time. In fact some banks include FX forward traders under their interest rate segment rather than
FX segment.
3.7 Forward point determination
The number of ‘basis points’ from the spot rate to arrive at the forward rate in the above
discussions is also referred to as forward points. The points are added to the spot rate when the
[foreign] currency is at a premium and deducted from the spot rate when the [foreign] currency is
at a discount, to arrive at the forward rate. This is when the rates are quoted in direct method. In
case of indirect rate quotations, the process will be exactly the opposite. The forward point may be
positive or negative and marked accordingly or specifically mentioned so. The forward points
represent the interest rate differential between the two currencies. E.g. if the spot exchange rate is
GBP 1 = 1.6000 - 1.6010 USD and if the outright forward points are 5-8, then the outright forward
exchange rate quote is GBP 1 = $ 1.6005 - 1.6018. The number of forward points between the
spot and forward is influenced by the present and forward interest rates, the ‘length’ of the forward
and other market factors. Forward point is not a rate but a difference in the rate between two
currencies, the currency which carries lower interest rate is always at a premium versus the other
currency. This is the same as stating that if a currency has a relatively higher ‘yield’, then it will
cost less in the forward market and a currency having lower yield will cost more in the forward
market. If there is an aberration to this, arbitration opportunity arises, which itself will push the
prices to equilibrium. If the forward points are mentioned simply as 5/8, then a doubt arises as to
whether it is at premium, and hence has to be added or at discount and hence to be deducted. The
spot market always has the lowest bid- ask spread and the spread will steadily widen as the
duration lengthens.
This is because the uncertainty and the liquidity concerns increase as we go forward in time. If we
add 5/8 to the left and right side, the spread will widen and hence fits into the argument.
Hence a quote such as 5/8 or 43/45 with increasing numbers from left to right means the foreign
currency is at premium. This looks like a workaround to calculate but the reader can visualize the
logic.
Forward points are equivalent to pips in the spot market which we discussed earlier. They are
quoted to an accuracy of 1/100 thof one point. E.g. if EUR/USD rates for spot and forward are
1.1323 & 1.1328, then the forward point is 5 because one pip or point is worth 0.0001 in
EUR/USD.
3.8 Broken period forward rate
Interbank exchange rates are wholesale rates which are applicable to transaction among banks
and in the interbank market. They are for large standard amounts with standardized due dates i.e.
end of January, end of February and so on. However, in customer transactions, the amounts are
not only smaller & for odd amounts, but the due date could be also a non standardized one. There
could be an export bill for euro 12,345.67 getting realized on 10 thJanuary or 23rdFebruary and so
on. Thus, the forward rate that is available in the interbank market [in the form of forward points for
February, for March and so on] cannot be applied as such for customer transactions. The broken
period concept becomes relevant in such situations.
On 1stJanuary, if the spot rate for US Dollar is ` 62 and if the forward margin for two months i.e. at
the end of February is 10 paise [premium], then the forward rate can be calculated as ` 62.10 per
USD and any customer transaction exchange rate can be calculated using this as the base rate.
Thus, if the bank wishes to keep a margin of say 3 paise, it will quote a rate of ` 62.13 for an
importer and quote a rate of ` 62.07 for an exporter. However, this logic is valid only for a bill to be
realized [for an exporter] or a bill to be paid [for an importer] on 28 thFebruary because the
underlying forward rate was for two months on 1 stJanuary i.e. the date of 28 thFebruary. However,
in customer transactions, the event [of converting FC into INR or vice versa] does not always
happen on the exact standard dates. Thus, if the bill is getting paid or is to be retired on
23rdFebruary, then the forward points are to be calculated for such odd number of days starting
from 1stJanuary. It will be presumed [though there is no logical answer, in practice, it turns out to
be adequately accurate], that the forward points ‘grow’ uniformly throughout and arithmetical
proportionate for the applicable date is arrived at. E.g. in the above instance, on 1 stJanuary, the
premium for a customer transaction expected to happen on 23 rdFebruary is calculated as
=10*53/59 = 8.98 paise [53 & 59 are broken & full periods] and hence the exchange rate will be
62.0898. As market convention, this will be rounded off to 62.09. The merchant forward rate for a
customer transaction expected to happen on 23rdFebruary will be this margin loaded onto spot
rate. Thus, if the margin is 3 paise, the rate for an exporter will be 62.06 & for an importer, the rate
will be 62.12. This logic will be applied even while calculating exchange rate for a third currency
though the calculation will be a bit lengthier.
3.9 Merchant Rates

It is always interesting to know who ‘fixes’ the exchange rates as quoted to customers and to
realize that nobody fixes but the market decides the exchange rate based on demand and supply
and other relevant factors. RBI often clarifies that it does not fix the exchange rates, though in the
same breath, RBI also clarifies that it monitors the ‘volatility’ of Indian rupee exchange rate. In
other words, RBI does not control the exchange rates but it controls the volatile movement of INR
exchange rate by intervention i.e. by deliberately altering the demand and supply of the foreign
currency say USD. It does it by either buying USD from the interbank market or pumping in USD
into the market. This wholesale interbank market rate is the basis for banks’ exchange rates
quoted to customers.
In foreign exchange market, banks consider customers as ‘merchants’ for historical reasons. It
may look ridiculous to call an NRI who has remitted dollars to India as a merchant but exchange
rates applied to all types of customers including that for converting inward remittance in USD to
INR are called merchant rates as against the rates quoted to each other by banks in the interbank
market, which are called interbank rates. Why this term is important here is because there are
guidelines issued by FEDAI [Foreign Exchange Dealers Association of India] to banks on these
merchant rates as there is customer service element involved in these.
Till 1998, FEDAI prescribed what ‘margins’ are to be loaded by banks onto the ongoing interbank
exchange rate for quoting to customers i.e. to arrive at the merchant rates. This was because,
most customer affecting costs like interest rates were then controlled by regulators.
As a part of liberalization, banks got the freedom to quote their own rates. Since then, banks
decide themselves what should be the margin depending on the bank’s ‘position’. The only rule
that is still existing in the FEDAI rule book is rule 5A.8 which states t hat “Settlement of all
merchant transactions shall be effected on the principle of rounding off the Rupee amounts to the
nearest whole Rupee i.e., without paise”. This means if an exporter or an individual has received
USD 1234 and if the applicable exchange rate is 61.32, then the amount to be credited to
customer’s account is ` 75669 and not ` 75668.88, less charges if any. This rule will be similarly
applicable for import or outward remittance transactions also. This rule is more a matter of
common sense and does not have any meaningful impact on customer transactions. In fact in
some of the banking software, amount is always rounded off.
After the discontinuation of gold standard in 1971 by USA, the foreign exchange market was in
turmoil. Initially, RBI had kept sterling as the intervention currency pegging the rupee exchange
rate for historical reasons and due to political legacy. Effective 1975, rupee was delinked from
sterling and was linked to a basket of currencies. It should be noted that the concept of RBI/FEDAI
advising the fixed exchange rate was discontinued long ago. The sterling schedule was abolished
from the beginning of 1984. FEDAI issued detailed guidelines to banks on how to calculate
exchange rates under the new freedom, the minimum & maximum profit margin and the maximum
spread between the buying and selling rates. All these are now redundant now. There were
arguments for and against giving freedom to banks for loading margins by banks themselves on
the ongoing interbank rate. However, the liberalization wave overruled the skeptics.
The International Division of any bank calculates the merchant rates for variety of transactions like
import bill, export bill, inward & outward remittance etc. and advises the same in the morning with
standard spread loaded to all branches. It is called card rate. For a walk-in customer, for
transactions of small value [what is small varies with the bank], this is applied.
However, for regular customers and for transactions of high value, always a better rat e is sought
from the dealing room. Card rates advised in the margin are generally not changed unless there is
too much volatility.
4. EXCHANGE RATE FORECASTING

The foreign exchange market has changed dramatically over the past few years. The amounts
traded each day in the foreign exchange market are now huge. In this increasingly challenging and
competitive market, investors and traders need tools to select and analyze the right data from the
vast amounts of data available to them to help them make good decisions. Corporates need to do
the exchange rate forecasting for taking decisions regarding hedging, short -term financing, short-
term investment, capital budgeting, earnings assessments and long-term financing.
Techniques of Exchange Rate Forecasting: There are numerous methods available for
forecasting exchange rates. They can be categorized into four general groups - technical,
fundamental, market-based and mixed.
(a) Technical Forecasting: It involves the use of historical data to predict future values. For
example time series models. Speculators may find the models useful for predicting day -to-day
movements. However, since the models typically focus on the near future and rarely provide point
or range estimates, they are of limited use to MNCs.
(b) Fundamental Forecasting: It is based on the fundamental relationships between economic
variables and exchange rates. For example subjective assessments, quantitative measurements
based on regression models and sensitivity analyses.
In general, fundamental forecasting is limited by:
❖ the uncertain timing of the impact of the factors,
❖ the need to forecast factors that have an immediate impact on exchange rates,
❖ the omission of factors that are not easily quantifiable and
❖ changes in the sensitivity of currency movements to each factor over time.
(c) Market-Based Forecasting: It uses market indicators to develop forecasts. The current
spot/forward rates are often used, since speculators will ensure that the current rates reflect the
market expectation of the future exchange rate.
(d) Mixed Forecasting: It refers to the use of a combination of forecasting techniques. The
actual forecast is a weighted average of the various forecasts developed.
5. EXCHANGE RATE DETERMINATION

An exchange rate is, simply, the price of one nation’s currency in terms of another currency, often
termed the reference currency. For example, the rupee/dollar exchange rate is just the number of
rupee that one dollar will buy. If a dollar will buy 100 rupee, the exchange rate woul d be expressed
as ` 100/$ and the rupee would be the reference currency.
Equivalently, the dollar/ rupee exchange rate is the number of dollars one rupee will buy.
Continuing the previous example, the exchange rate would be $0.01/Rs (1/100) and the dollar
would now be the reference currency. Exchange rates can be for spot or forward delivery.
The foreign exchange market includes both the spot and forward exchange rates. The spot rate is
the rate paid for delivery within two business days after the day the transaction takes place. If the
rate is quoted for delivery of foreign currency at some future date, it is called the forward rate. In
the forward rate, the exchange rate is established at the time of the contract, though payment and
delivery are not required until maturity. Forward rates are usually quoted for fixed periods of 30,
60, 90 or 180 days from the day of the contract.
(a) The Spot Market: The most common way of stating a foreign exchange quotation is in
terms of the number of units of foreign currency needed to buy one unit of home currency. Thus,
India quotes its exchange rates in terms of the amount of rupees that can be exchanged for one
unit of foreign currency.
Illustration 2
If the Indian rupee is the home currency and the foreign currency is the US Dollar then what is the
exchange rate between the rupee and the US dollar?
Solution
US$ 0.0217/`1 reads "0.0217 US dollar per rupee." This means that for one Indian rupee one can
buy 0.0217 US dollar.
In this method, known as the European terms, the rate is quoted in terms of the number of units of
the foreign currency for one unit of the domestic currency. This is called an indirect quote.
The alternative method, called the American terms, expresses the home currency price of one unit
of the foreign currency. This is called a direct quote.
This means the exchange rate between the US dollar and rupee can be expressed as:
` 46.08/US$ reads "` 46.08 per US dollar."
Hence, a relationship between US dollar and rupee can be expressed in two d ifferent ways which
have the same meaning:
❖ One can buy 0.0217 US dollars for one Indian rupee.

❖ ` 46.08 Indian rupees are needed to buy one US dollar.
(b) The Forward Market: A forward exchange rate occurs when buyers and sellers of
currencies agree to deliver the currency at some future date. They agree to transact a specific
amount of currency at a specific rate at a specified future date. The forward exchange rate is set
and agreed by the parties and remains fixed for the contract period regardless of t he fluctuations in
the spot exchange rates in future. The forward exchange transactions can be understood by an
example.
A US exporter of computer peripherals might sell computer peripherals to a German importer with
immediate delivery but not require payment for 60 days. The German importer has an obligation to
pay the required dollars in 60 days, so he may enter into a contract with a trader (typically a local
banker) to deliver Euros for dollars in 60 days at a forward rate – the rate today for future delivery.
So, a forward exchange contract implies a forward delivery at specified future date of one currency
for a specified amount of another currency. The exchange rate is agreed today, though the actual
transactions of buying and selling will take place on the specified date only. The forward rate is not
the same as the spot exchange rate that will prevail in future. The actual spot rate that may prevail
on the specified date is not known today and only the forward rate for that day is known. The
actual spot rate on that day will depend upon the supply and demand forces on that day. The
actual spot rate on that day may be lower or higher than the forward rate agreed today.
An Indian exporter of goods to London could enter into a forward contract with his banker to sell
pound sterling 90 days from now. This contract can also be described as a contract to purchase
Indian Rupees in exchange for delivery of pound sterling. In other words, foreign exchange
markets are the only markets where barter happens – i.e., money is delivered in exchange for
money!
6. EXCHANGE RATE THEORIES

There are three theories of exchange rate determination- Interest rate parity, Purchasing power
parity and International Fisher effect.
6.1 Interest Rate Parity (IRP)
Interest Rate Parity is a theory which states that ‘the size of the forward premium (or discount)
should be equal to the interest rate differential between the two countries of concern”. When
interest rate parity exists, covered interest arbitrage (means foreign exchange risk is covered) is
not feasible because any interest rate advantage in the foreign country will be offset by the
discount on the forward rate. Thus, the act of covered interest arbitrage would generate a return
that is no higher than what would be generated by a domestic investment.
The Covered Interest Rate Parity equation is given by:

F
(1 + rD ) = (1 + rF )
S
Where,
(1 + rD) = Amount that an investor would get after a unit period by investing a rupee in the
F
domestic market at r D rate of interest and (1 + rF ) is the amount that an investor by
S
investing in the foreign market at r F that the investment of one rupee yield same return in
the domestic as well as in the foreign market.
The Uncovered Interest Rate Parity equation is given by:
S1
r + rD = (1 + rF )
S
Where,
S1 = Expected future spot rate when the receipts denominated in foreign currency is converted into
domestic currency.
Thus, it can be said that Covered Interest Arbitrage has an advantage as there is an incentive to
invest in the higher-interest currency to the point where the discount of that currency in the forward
market is less than the interest differentials. If the discount on the forward market of the currency
with the higher interest rate becomes larger than the interest differential, then it pays to invest in
the lower-interest currency and take advantage of the excessive forward premium on this currency.
6.2 Purchasing Power Parity (PPP)
Why is a dollar worth ` 48.80, JPY 122.18, etc. at some point of time? One possible answer is
that these exchange rates reflect the relative purchasing powers of the currencies, i.e. the basket
of goods that can be purchased with a dollar in the US will cost ` 48.80 in India and ¥ 122.18 in
Japan.
Purchasing Power Parity theory focuses on the ‘inflation – exchange rate’ relationship. There are
two forms of PPP theory:-
The ABSOLUTE FORM, also called the ‘Law of One Price’ suggests that “prices of similar
products of two different countries should be equal when measured in a common currency”. If a
discrepancy in prices as measured by a common currency exists, the demand should shift so that
these prices should converge.
An alternative version of the absolute form that accounts for the possibility of market imperfections
such as transportation costs, tariffs, and quotas embeds the sectoral constant. It suggests that
‘because of these market imperfections, prices of similar products of different countries will not
necessarily be the same when measured in a common currency.’ However, it states that the rate of
change in the prices of products should be somewhat similar when measured in a common
currency, as long as the transportation costs and trade barriers are unchanged.
In Equilibrium Form:
PD
S=α
PF
Where,
S(`/$) = spot rate
PD = is the price level in India, the domestic market.
PF = is the price level in the foreign market, the US in this case.
α = Sectoral price and sectoral shares constant.
For example, A cricket bat sells for ` 1000 in India. The transportation cost of one bat from
Ludhiana to New York costs ` 100 and the import duty levied by the US on cricket bats is
` 200 per bat. Then the sectoral constant for adjustment would be 1000/1300 = 0.7692.
It becomes extremely messy if one were to deal with millions of products and millions of constants.
One way to overcome this is to use a weighted basket of goods in the two countries represented
by an index such as Consumer Price Index. However, even this could break down because the
basket of goods consumed in a country like Finland would vary with the consumption pattern in a
country such as Malaysia making the aggregation an extremely complicated exercise.
The RELATIVE FORM of the Purchasing Power Parity tries to overcome the pr oblems of market
imperfections and consumption patterns between different countries. A simple explanation of the
Relative Purchase Power Parity is given below:
Assume the current exchange rate between INR and USD is ` 50 / $1. The inflation rates are 12%
in India and 4% in the US. Therefore, a basket of goods in India, let us say costing now ` 50 will
cost one year hence ` 50 x 1.12 = ` 56.00.A similar basket of goods in the US will cost USD 1.04
one year from now. If PPP holds, the exchange rate between USD and INR, one year hence,
would be ` 56.00 = $1.04. This means, the exchange rate would be ` 53.8462 / $1, one year from
now. This can also be worked backwards to say what should have been the exchange rate one
year before, taking into account the inflation rates during last year and the current spot rate.
Expected spot rate = Current Spot Rate x expected difference in inflation rates
(1 + Id )
E(S1) = S0 x
(1 + 1f )
Where
E(S1) is the expected Spot rate in time period 1
S0 is the current spot rate (Direct Quote)
Id is the inflation in the domestic country (home country)

If is the inflation in the foreign country
According to Relative PPP, any differential exchange rate to the one propounded by the theory is
the ‘real appreciation’ or ‘real depreciation’ of one currency over the other. For example, if the
exchange rate between INR and USD one year ago was ` 45.00. If the rates of inflation in India
and USA during the last one year were 10% and 2% respectively, the spot ex change rate between
the two currencies today should be
S0 = 45.00 x (1+10%)/(1+2%) = ` 48.53
However, if the actual exchange rate today is ` 50,00, then the real appreciation of the USD
against INR is ` 1.47, which is 1.47/45.00 = 3.27% and this appreciation of the USD against INR
is explained by factors other than inflation.
PPP is more closely approximated in the long run than in the short run, and when disturbances are
purely monetary in character.
6.3 International Fisher Effect (IFE)
International Fisher Effect theory uses interest rate rather than inflation rate differentials to explain
why exchange rates change over time but it is closely related to the Purchasing Power Parity
(PPP) theory because interest rates are often highly correlated with inflation rates.
According to the International Fisher Effect, ‘nominal risk-free interest rates contain a real rate of
return and anticipated inflation’. This means if investors of all countries require the same real
return, interest rate differentials between countries may be the result of differential in expected
inflation.
The IFE theory suggests that foreign currencies with relatively high interest rates will depreciate
because the high nominal interest rates reflect expected inflation. T he nominal interest rate would
also incorporate the default risk of an investment.
The IFE equation can be given by:
rD – PD = rF – PF
or
PD – PF = S = rD –rF
The above equation states that if there are no barriers to capital flows the investment will fl ow in
such a manner that the real rate of return on investment will equalize. In fact, the equation
represents the interaction between real sector, monetary sector and foreign exchange market.
If the IFE holds, then a strategy of borrowing in one country and investing the funds in another
country should not provide a positive return on average. The reason is that exchange rates should
adjust to offset interest rate differentials on the average. As we know that purchasing power has
not held over certain periods and since the International Fisher Effect is based on Purchasing
Power Parity (PPP). It does not consistently hold either because there are factors other than
inflation that affect exchange rates, the exchange rates do not adjust in accordance with the
inflation differential.
6.4 Comparison of PPP, IRP and IFE Theories
All the above theories relate to the determination of exchange rates. Yet, they differ in their
implications.
The theory of IRP focuses on why the forward rate differs from the spot r ate and on the degree of
difference that should exist. This relates to a specific point of time.
Conversely, PPP theory and IFE theory focuses on how a currency’s spot rate will change over
time. While PPP theory suggests that the spot rate will change in accordance with inflation
differentials, IFE theory suggests that it will change in accordance with interest rate differentials.
PPP is nevertheless related to IFE because inflation differentials influence the nominal interest
rate differentials between two countries.
Theory Key Variables Basis Summary
Interest Rate Parity Forward rate Interest rate The forward rate of one
(IRP) premium (or differential currency will contain a
discount) premium (or discount) that is
determined by the differential
in interest rates between the
two countries. As a result,
covered interest arbitrage will
provide a return that is no
higher than a domestic return.
Purchasing Power Percentage Inflation rate The spot rate of one currency
Parity (PPP) change in spot differential. w.r.t. another will change in
exchange rate. reaction to the differential in
inflation rates between two
countries. Consequently, the
purchasing power for
consumers when purchasing
goods in their own country will
be similar to their purchasing
power when importing goods
from foreign country.
International Fisher Percentage Interest rate The spot rate of one currency
Effect (IFE) change in spot differential w.r.t. another will change in
exchange rate accordance with the
differential in interest rates
between the two countries.
Consequently, the return on

uncovered foreign money
market securities will on
average be no higher than the
return on domestic money
market securities from the
perspective of investors in the
home country.
7. FOREIGN EXCHANGE MARKET

The Foreign Exchange market is the market in which individuals, firms and banks buy and sell
foreign currencies or foreign exchange. The purpose of the foreign exchange market is to permit
transfers of purchasing power denominated in one currency to another i.e. to trade one currency
for another. For example, a Japanese exporter sells automobiles to a US dealer for dollars, and a
US manufacturer sells machine tools to Japanese company for yen. Ultimately, however, the US
company will be interested in receiving dollars, whereas the Japanese exporter will want yen
because it would be inconvenient for the individual buyers and sellers of foreig n exchange to seek
out one another, a foreign exchange market has developed to act as an intermediary.
Transfer of purchasing power is necessary because international trade and capital transactions
usually involve parties living in countries with different national currencies. Each party wants to
trade and deal in his own currency but since the trade can be invoiced only in a single currency,
the parties mutually agree on a currency beforehand. The currency agreed could also be any
convenient third country currency such as the US dollar. For, if an Indian exporter sells machinery
to a UK importer, the exporter could invoice in pound, rupees or any other convenient currency like
the US dollar.
But why do individuals, firms and banks want to exchange one national currency for another? The
demand for foreign currencies arises when tourists visit another country and need to exchange
their national currency for the currency of the country they are visiting or when a domestic firm
wants to import from other nations or when an individual wants to invest abroad and so on. On the
other hand, a nation's supply of foreign currencies arises from foreign tourist expenditures in the
nation, from export earnings, from receiving foreign investments, and so on. For example, suppose
a US firm exporting to the UK is paid in pounds sterling (the UK currency). The US exporter will
exchange the pounds for dollars at a commercial bank. The commercial bank will then sell these
pounds for dollars to a US resident who is going to visit the UK or to a United States firm that
wants to import from the UK and pay in pounds, or to a US investor who wants to invest in the UK
and needs the pounds to make the investment.
Thus, a nation's commercial banks operate as clearing houses for the fore ign exchange demanded
and supplied in the course of foreign transactions by the nation's residents. Hence, four levels of
transactor or participants can be identified in foreign exchange markets. At the first level, are
tourists, importers, exporters, investors, etc. These are the immediate users and suppliers of
foreign currencies. At the next or second level are the commercial banks which act as clearing
houses between users and earners of foreign exchange. At the third level are foreign exchange
brokers through whom the nation's commercial banks even out their foreign exchange inflows and
outflows among themselves. Finally, at the fourth and highest level is the nation's central bank
which acts as the lender or buyer of last resort when the nation's total foreign exchange earnings
and expenditures are unequal. The central bank then either draws down its foreign exchange
reserves or adds to them.
Market Participants
The participants in the foreign exchange market can be categorized as follows:
(i) Non-bank Entities: Many multinational companies exchange currencies to meet their
import or export commitments or hedge their transactions against fluctuations in exchange
rate. Even at the individual level, there is an exchange of currency as per the need s of the
individual.
(ii) Banks: Banks also exchange currencies as per the requirements of their clients.
(iii) Speculators: This category includes commercial and investment banks, multinational
companies and hedge funds that buy and sell currencies with a view to ea rn profit due to
fluctuations in the exchange rates.
(iv) Arbitrageurs: This category includes those investors who make profit from price differential
existing in two markets by simultaneously operating in two different markets.
(v) Governments: The governments participate in the foreign exchange market through the
central banks. They constantly monitor the market and help in stabilizing the exchange
rates.
8. FOREIGN EXCHANGE EXPOSURE

“An Exposure can be defined as a Contracted, Projected or Contingent Cash Fl ow whose
magnitude is not certain at the moment. The magnitude depends on the value of variables such as
Foreign Exchange rates and Interest rates.”
In other words, exposure refers to those parts of a company’s business that would be affected if
exchange rate changes. Foreign exchange exposures arise from many different activities.
For example, travellers going to visit another country have the risk that if that country's currency
appreciates against their own their trip will be more expensive.
An exporter who sells his product in foreign currency has the risk that if the value of that foreign
currency falls then the revenues in the exporter's home currency will be lower.
An importer who buys goods priced in foreign currency has the risk that the foreign cur rency will
appreciate thereby making the local currency cost greater than expected.
Fund Managers and companies who own foreign assets are exposed to fall in the currencies
where they own the assets. This is because if they were to sell those assets their exchange rate
would have a negative effect on the home currency value.
Other foreign exchange exposures are less obvious and relate to the exporting and importing in
ones local currency but where exchange rate movements are affecting the negotiated price.
8.1 Types of Exposures
The foreign exchange exposure may be classified under three broad categories:
Moment in time when exchange rate changes
Translation exposure Operating exposure

Change in expected cash flows arising
Accounting-based changes in
because of an unexpected change in
consolidated financial statements
exchange rates
caused by a change in exchange
rates
Transaction exposure
Impact of setting outstanding obligations entered into before change in
exchange rates but to be settled after the change in exchange rates
Time
8.1.1 Transaction Exposure
8
It measures the effect of an exchange rate change on outstanding obligations that existed before
exchange rates changed but were settled after the exchange rate changes. Thus, it deals with
cash flows that result from existing contractual obligations.
Example: If an Indian exporter has a receivable of $100,000 due in six months hence and if the
dollar depreciates relative, to the rupee a cash loss occurs. Conversely, if the dollar appreciates
relative to the rupee, a cash gain occurs.
The above example illustrates that whenever a firm has foreign currency denominated receivables
or payables, it is subject to transaction exposure and their settlements will affect the firm’s cash
flow position.
It measures the changes in the value of outstanding financial obligation incurred prior to a change
in exchange rates but not due to be settled until after the exchange rates change.
Thus, it deals with the changes in the cashflow which arise from existing contractual obligation.
In fact, the transaction exposures are the most common ones amongst all the exposures. Let’s
take an example of a company which exports to US and the export receivables are also
denominated in USD. While doing budgeting the company had assumed USD/INR rate of ` 62 per
USD. By the time the exchange inward remittance arrives. USD/INR could move down to ` 57
leading to wiping off of commercial profit for exporter. Such transaction exposures arise whenever
a business has foreign currency denominated receipts or payments. The risk is an adverse
movement of the exchange rate from the time the transaction is budgeted till the time the exposure
is extinguished by sale or purchase of the foreign currency against the domestic currency.
8.1.2 Translation Exposure
Also known as accounting exposure, it refers to gains or losses caused by the translation of
foreign currency assets and liabilities into the currency of the parent company for consolidation
purposes.
Translation exposure, also called as accounting exposure, is the potential for accounting derived
changes in owner’s equity to occur because of the need to “translate” foreign currency financial
statements of foreign subsidiaries into a single reporting currency to prepare worldwide
consolidated financial statements.
Translation exposures arise due to the need to “translate” foreign currency assets and liabilities
into the home currency for the purpose of finalizing the accounts for any given period. A typical
example of translation exposure is the treatment of foreign currency loans.
Consider that a company has taken a medium term loan to finance the import of capital goods
worth dollars 1 million. When the import materialized, the exchange rate was, say, USD/INRR -55.
The imported fixed asset was, therefore, capitalized in the books of the company at ` 550 lacs
through the following accounting entry:
Debit fixed assets ` 550 lacs
Credit dollar loan ` 550 lacs
In the ordinary course assuming no change in the exchange rate, the company would have
provided depreciation on the asset valued at ` 550 lacs, for finalizing its account for the year in
which the asset was purchased.
However, what happens if at the time of finalization of the accounts the exchange rate has moved
to say USD/INR-58. Now the dollar loan will have to be “translated” at ` 58, involving a “translation
loss” of a ` 30 lacs. It shall have to be capitalized by increasing the book value of the asset, thus
making the figure ` 380 lacs and consequently higher depreciation will have to be provided, thus
reducing the net profit.
It will be readily seen that both transaction and translation expos ures affect the bottom line of a
company. The effect could be positive as well if the movement is favourable – i.e., in the cited
examples, in case the USD would have appreciated and the USD would have depreciated against
the rupee.
An important observation is that the translation exposure, of course, becomes a transaction
exposure at some stage: the dollar loan has to be repaid by undertaking the transaction of
purchasing dollars.
8.1.3 Economic Exposure
It refers to the extent to which the economic value of a company can decline due to changes in
exchange rate. It is the overall impact of exchange rate changes on the value of the firm. The
essence of economic exposure is that exchange rate changes significantly alter the cost of a firm’s
inputs and the prices of its outputs and thereby influence its competitive position substantially.
Effects of Local Currency Fluctuations on Company’s Economic Exposure (Cash inflow)
Variables influencing the inflow Revaluation Devaluation
of cash in Local currency impact impact
Local sale, relative to foreign Decrease Increase
Competition in local currency
Company’s export in local currency Decrease Increase
Company’s export in foreign currency Decrease Increase
Interest payments from foreign investments Decrease Increase
Effects of Local Currency Fluctuations on Company’s Economic Exposure (Cash outflow)
Variables influencing the Revaluation Devaluation
outflow of cash in local currency impact impact
Company’s import of material Remain the same Remain the same
the same denoted in local currency
Company’s import of material Decrease Increase
denoted in foreign currency
Interest on foreign debt Decrease Increase
9. HEDGING CURRENCY RISK

There are a range of hedging instruments that can be used to reduce risk. Broadly these
techniques can be divided into
(A) Internal Techniques: These techniques explicitly do not involve transaction costs and can be
used to completely or partially offset the exposure. These techniques can be further classified as
follows:
(i) Invoicing in Domestic Currency: Companies engaged in exporting and importing, whether
of goods or services, are concerned with decisions relating to the currency in which goods and
services are invoked. Trading in a foreign currency gives rise to transaction exposure. Although
trading purely in a company's home currency has the advantage of simplicity, it fails to take
account of the fact that the currency in which goods are invoiced has become an essential aspect
of the overall marketing package given to the customer. Sellers will usually wish to sell in their own
currency or the currency in which they incur cost. This avoids foreign exchange exposure but
buyers' preferences may be for other currencies. Many markets, such as oil or aluminum, in effect
require that sales be made in the same currency as that quoted by major competitors, which may
not be the seller's own currency. In a buyer's market, sellers tend increasingly to invoice in the
buyer's ideal currency. The closer the seller can approximate the buyer's aims, the greater chance
he or she has to make the sale.
Should the seller elect to invoice in foreign currency, perhaps because the prospective customer
prefers it that way or because sellers tend to follow market leader, then the seller should choose
only a major currency in which there is an active forward market for maturities at least as long as
the payment period. Currencies, which are of limited convertibility, chronically weak, or with only a
limited forward market, should not be considered.
The seller’s ideal currency is either his own, or one which is stable relative to it but often the seller
is forced to choose the market leader’s currency. Whatever the chosen currency, it should certainly
be one with a deep forward market. For the buyer, the ideal currency is usually its own or one that
is stable relative to it, or it may be a currency of which the purchaser has reserves.
(ii) Leading and Lagging: Leading and Lagging refer to adjustments at the time of payments
in foreign currencies. Leading is the payment before due date while lagging is delaying pay ment
post the due date. These techniques are aimed at taking advantage of expected devaluation
and/or revaluation of relevant currencies. Lead and lag payments are of special importance in the
event that forward contracts remain inconclusive. For example, Subsidiary b in B country owes
money to subsidiary a in country A with payment due in three months’ time and with the debt
denominated in US dollar. On the other side, country B’s currency is expected to devalue within
three months against US dollar, vis-à-vis country A’s currency. Under these circumstances, if
company b leads -pays early - it will have to part with less of country B’s currency to buy US
dollars to make payment to company A. Therefore, lead is attractive for the company. When we
take reverse the example-revaluation expectation- it could be attractive for lagging.
(iii) Netting: Netting involves associated companies, which trade with each other. The
technique is simple. Group companies merely settle inter affiliate indebted ness for the net amount
owing. Gross intra-group trade, receivables and payables are netted out. The simplest scheme is
known as bilateral netting and involves pairs of companies. Each pair of associates nets out their
own individual positions with each other and cash flows are reduced by the lower of each
company's purchases from or sales to its netting partner. Bilateral netting involves no attempt to
bring in the net positions of other group companies.
Netting basically reduces the number of inter company payments and rec eipts which pass over the
foreign exchanges. Fairly straightforward to operate, the main practical problem in bilateral netting
is usually the decision about which currency to use for settlement.
Netting reduces banking costs and increases central control of inter company settlements. The
reduced number and amount of payments yield savings in terms of buy/sell spreads in the spot
and forward markets and reduced bank charges.
(iv) Matching: Although netting and matching are terms which are frequently used
interchangeably, there are distinctions. Netting is a term applied to potential flows within a group of
companies whereas matching can be applied to both intra-group and to third-party balancing.
Matching is a mechanism whereby a company matches its foreign currency inflows with its foreign
currency outflows in respect of amount and approximate timing. Receipts in a particular currency
are used to make payments in that currency thereby reducing the need for a group of companies
to go through the foreign exchange markets to the unmatched portion of foreign currency cash
flows.
The prerequisite for a matching operation is a two-way cash flow in the same foreign currency
within a group of companies; this gives rise to a potential for natural mat ching. This should be
distinguished from parallel matching, in which the matching is achieved with receipt and payment
in different currencies but these currencies are expected to move closely together, near enough in
parallel.
Both Netting and Matching presuppose that there are enabling Exchange Control regulations. For
example, an MNC subsidiary in India cannot net its receivable(s) and payable(s) from/to its
associated entities. Receivables have to be received separately and payables have to be paid
separately.
(v) Price Variation: Price variation involves increasing selling prices to counter the adverse
effects of exchange rate change. This tactic raises the question as to why the company has not
already raised prices if it is able to do so. In some countries, price increases are the only legally
available tactic of exposure management.
Let us now concentrate to price variation on inter company trade. Transfer pricing is the term used
to refer to the pricing of goods and services, which change hands within a group of companies. As
an exposure management technique, transfer price variation refers to the arbitrary pricing of inter
company sales of goods and services at a higher or lower price than the fair price, arm’s length
price. This fair price will be the market price if there is an existing market or, if there is not, the
price which would be charged to a third party customer. Taxation authorities, customs and excise
departments and exchange control regulations in most countries require that the arm’s length
pricing should be used.
(vi) Asset and Liability Management: This technique can be used to manage balance sheet,
income statement or cash flow exposures. Concentration on cash flow exposure makes economic
sense but emphasis on pure translation exposure is misplaced. Hence our focus here is on asset
liability management as a cash flow exposure management technique.
In essence, asset and liability management can involve aggressive or defensive postures. In the
aggressive attitude, the firm simply increases exposed cash inflows denominated in currencies
expected to be strong or increases exposed cash outflows denominated in weak currencies. By
contrast, the defensive approach involves matching cash inflows and outflows according to their
currency of denomination, irrespective of whether they are in strong or weak currencies.
(B) External Techniques: Under this category range of various financial products are used which
can be categorized as follows:
(i) Money Market Hedging: At its simplest, a money market hedge is an agreement to
exchange a certain amount of one currency for a fixed amount of another currency, at a particular
date. For example, suppose a business owner in India expects to receive 1 Million USD in six
months. This Owner could create an agreement now (today) to exchange 1Million USD for INR at
roughly the current exchange rate. Thus, if the USD dropped in value by the time the business
owner got the payment, he would still be able to exchange the payment for the original quantity of
U.S. dollars specified.
Advantages and Disadvantages of Money Market Hedge: Following are the advantages and
disadvantages of this technique of hedging.
Advantages
(a) Fixes the future rate, thus eliminating downside risk exposure.
(b) Flexibility with regard to the amount to be covered.
(c) Money market hedges may be feasible as a way of hedging for currencies where forward
contracts are not available.
Disadvantages include:
(a) More complicated to organise than a forward contract.
(b) Fixes the future rate - no opportunity to benefit from favourable movements in exchange
rates.
(ii) Derivative Instruments: A derivatives transaction is a bilateral contract or payment
exchange agreement whose value depends on - derives from - the value of an underlying asset,
reference rate or index. Today, derivatives transactions cover a broad range of underlying -
interest rates, exchange rates, commodities, equities and other indices.
In addition to privately negotiated, global transactions, derivatives also include standardized
futures and options on futures that are actively traded on organized exchanges and securities such
as call warrants.
The term derivative is also used to refer to a wide variety of other instruments. These have payoff
characteristics, which reflect the fact that they include derivatives products as part of their make -
up.
Transaction risk can also be hedged using a range of financial derivatives products which include:
Forwards, futures, options, swaps, etc. These instruments are discussed in detailed manner in
following pages.
10. FORWARD CONTRACT

The simplest form of derivatives is the forward contract. It obliges one party to buy, and the other
to sell, a specified quantity of a nominated underlying financial instrument at a specific price, on a
specified date in the future. There are markets for a multitude of underlying. Among these are the
traditional agricultural or physical commodities, currencies (foreign exchange forwards) and
interest rates (forward rate agreements - FRAs). The volume of trade in forward contracts is
massive.
10.1 Forward Rate – Premium and Discount
The change in value in a forward contract is broadly equal to the change in value in the underlying.
Forwards differ from options in that options carry a different payoff profile. Forward contracts are
unique to every trade. They are customized to meet the specific requirements of each end-user.
The characteristics of each transaction include the particular business, financial or risk -
management targets of the counterparties. Forwards are not standardized. The terms in relation to
contract size, delivery grade, location, delivery date and credit period are always negotiated.
In a forward contract, the buyer of the contract draws its value at maturity from its delivery terms or
a cash settlement. On maturity, if the price of the underlying is higher than the contract price the
buyer makes a profit. If the price is lower, the buyer suffers a loss. The gain to the buyer is a loss
to the seller.
❖ Forwards Rates: The forward rate is different from the spot rate. Depending upon whether the
forward rate is greater than the spot rate, given the currency in consideration, the forward may
either be at a 'discount' or at a 'premium'. Forward premiums and discounts are usually
expressed as an annual percentages of the difference between the spot and the forward rates.
❖ Premium: When a currency is costlier in forward or say, for a future value date, it is said to
be at a premium. In the case of direct method of quotation, the premium is added to both
the selling and buying rates.
❖ Discount: If the currency is cheaper in forward or for a future value date, it is said to be at a
discount. In case of direct quotation the discount is deducted from both the selling and
buying rate. The following example explains how to calculate Premium / Discount bot h
under Indirect/Direct quotes.
To calculate the Premium or Discount of a currency vis-à-vis another, we need to find out how
much each unit of the first currency can buy units of the second currency. For instance, if the Spot
rate between INR and USD is ` 55 to a dollar and the six months forward rate is ` 60 to a dollar, it
is clear the USD is strengthening against the Rupee and hence is at a premium which also means
that Rupee is at discount.
The premium of USD against INR is ` 5 for six months in absolute terms. However, forward
premium is always expressed as an annual percentage. Therefore, this premium is calculated as
[ (Forward Rate – Spot rate) / (Spot rate) ] x (12/6)
= (60 – 55 )/(55) x 12/6 = 18.18%
Rupee is at discount and to calculate the discount, we need to find out how many dollars each
Rupee can buy today and six months from now. Therefore, the Spot rate of USD in terms of INR
today is USD 1/55 = $ 0.01818 and six months from now is USD 1/60 = $ 0.01667. The d iscount is
calculated as:
[ (Forward Rate – Spot rate) / (Spot rate) ] x (12/6)
= (0.01667 – 0.01818) / 0.01818 x 12/6
= – 0.00151 / 0.01818 x 12/6 = – 16.61%
The minus sign implies that the Rupee is at discount.
Another important point to be noted in the above example, is that the forward premiums do not
equal forward discount always. In the aforesaid example, for instance, the rupee is trading at a
discount of 16.67% while the dollar is trading at a premium of 18.18%.
10.2 Fate of Forward Contracts
Whenever any forward contract is entered, normally it meets any of the following three fates.
(A) Delivery under the Contract
(B) Cancellation of the Contract
(C) Extension of the Contract
Further above of fates of forward contract can further classified into following sub-categories.
(A) Delivery under the Contract
(i) Delivery on Due Date
(ii) Early Delivery
(iii) Late Delivery
(B) Cancellation of the Contract

(i) Cancellation on Due Date
(ii) Early Cancellation
(iii) Late Cancellation
(C) Extension of the Contract
(i) Extension on Due Date
(ii) Early Extension
(iii) Late Extension
Let us discuss each of above executions one by one.
Delivery on Due Date
This situation does not pose any problem as rate applied for the transaction would be rate
originally agreed upon. Exchange shall take place at this rate irrespective of the spot rate
prevailing.
Illustration 3
On 1st June 2015 the bank enters into a forward contract for 2 months for selling US$ 1,00,000 at
` 65.5000. On 31st July 2015 the spot rate was ` 65.7500/65.2500. Calculate the amount to be
debited in the customer’s account.
Solution
The bank will apply rate originally agreed upon i.e. ` 65.5000 and will debit the account of the
customer with ` 65,50,000.
Early Delivery
The bank may accept the request of customer of delivery before due date of forward contract
provided the customer is ready to bear the loss if any that may accrue to the bank as a result o f
this. In addition to some prescribed fixed charges bank may also charge additional charges
comprising of:
(a) Swap Difference: This difference can be loss/ gain to the bank. This arises on account of
offsetting its position earlier created by early delivery as bank normally covers itself against
the position taken in the original forward contract.
(b) Interest on Outlay of Funds: It might be possible early delivery request of a customer may
result in outlay of funds. In such bank shall charge from the customer at a rate not less than
prime lending rate for the period of early delivery to the original due date. However, if there
is an inflow of funds the bank at its discretion may pass on interest to the customer at the
rate applicable to term deposits for the same period.
Illustration 4
On 1 October 2015 Mr. X an exporter enters into a forward contract with a BNP Bank to sell US$
1,00,000 on 31 December 2015 at ` 65.40/$. However, due to the request of the importer, Mr. X
received amount on 28 November 2015. Mr. X requested the bank the take delivery of the
remittance on 30 November 2015 i.e. before due date. The inter-banking rates on 28 November
2015 was as follows:
Spot ` 65.22/65.27
One Month Premium 10/15
If bank agrees to take early delivery then what will be net inflow to Mr. X assuming that the
prevailing prime lending rate is 18%.
Solution
Bank will buy from customer at the agreed rate of ` 65.40. In addition to the same if bank will
charge/ pay swap difference and interest on outlay funds.
(a) Swap Difference
Bank Sells at Spot Rate on 28 November 2015 ` 65.22
Bank Buys at Forward Rate of 31 December 2015 (65.27 + 0.15) ` 65.42
Swap Loss per US$ ` 00.20
Swap loss for US$ 1,00,000 ` 20,000
(b) Interest on Outlay Funds
On 28th November Bank sells at ` 65.22
It buys from customer at ` 65.40
Outlay of Funds per US$ ` 00.18
Interest on Outlay fund for US$ 1,00,000 for 31 days ` 275.00
(US$100000 x 00.18 x 31/365 x 18%)
(c) Charges for early delivery
Swap loss ` 20,000.00
Interest on Outlay fund for US$ 1,00,000 for 31 days ` 275.00
` 20,275.00
(d) Net Inflow to Mr. X
Amount received on sale (` 65.40 x 1,00,000) ` 65,40,000
Less: Charges for early delivery payable to bank (` 20,275)
` 65,19,725
Late Delivery
In case of late delivery current rate prevailing on such date of delivery shall be applied. However,
before this delivery (execution) takes place the provisions of Automatic Cancellation (discussed
later on) shall be applied.
Cancellation on Due Date
In case of cancellation on due date in addition of flat charges (if any) the difference between
contracted rate and the cancellation rate (reverse action of original contract) is charged from/ paid
to the customer.
Illustration 5
On 15th January 2015 you as a banker booked a forward contract for US$ 250000 for your import
customer deliverable on 15th March 2015 at ` 65.3450. On due date customer request you to
cancel the contract. On this date quotation for US$ in the inter-bank market is as follows:
Spot ` 65.2900/2975 per US$
Spot/ April 3000/ 3100
Spot/ May 6000/ 6100
Assuming that the flat charges for the cancellation is ` 100 and exchange margin is 0.10%, then
determine the cancellation charges payable by the customer.
Solution
Bank will buy from customer at the agreed rate of ` 65.3450.
Since this is sale contract the contract shall be cancelled at ready buying rate on the date of
cancellation as follows:
Spot Buying Rate on 15 March 2015 ` 65.2900
Less: Exchange Margin ` 0.0653
` 65.2247
Rounded to ` 65.2250
Dollar sold to customer at ` 65.3450
Dollar bought from customer ` 65.2250
Net amount payable by the customer per US$ ` 0.1200
Amount payable by the customer
Flat Charges ` 100.00
Cancellation Charges (` 0.12 x 250000) `30,000.00
`30,100.00
Early Cancellation
If a forward is required to be cancelled earlier than the due date of forward contract same shall be
cancelled at opposite rate of original contract of the date that synchronises with the date of original
forward contract.
Illustration 6
You as a banker has entered into a 3 month’s forward contract with your customer to purchase
AUD 1,00,000 at the rate of ` 47.2500. However after 2 months your customer comes to you and
requests cancellation of the contract. On this date quotation for AUD in the market is as follows:
Spot ` 47.3000/3500 per AUD
1 month forward ` 47.4500/5200 per AUD
Determine the cancellation charges payable by the customer.
Solution
The contract shall be cancelled at the 1 month forward sale rate of ` 47.5200 as follows:
AUD bought from customer under original forward contract at ` 47.2500
On cancellation it is sold to him at ` 47.5200
Net amount payable by customer per AUD ` 00.2700
Thus total cancellation charges payable by the customer ` 27,000
Late Cancellation
In case of late cancellation of Forward Contract the provisions of Automatic Cancellation
(discussed later on) shall be applied.
Extension on Due Date
It might also be possible that an exporter may not be able to export goods on the due date.
Similarly it might also be possible that an importer may not to pay on due date. In both of these
situations an extension of contract for selling and buying contract is warranted. Accordingly, if
earlier contract is extended first it shall be cancelled and rebooked for the new delivery period. In
case extension is on due date it shall be cancelled at spot rate as like cancellation on due date
(discussed earlier) and new contract shall be rebooked at the forward rate for the new delivery
period.
Illustration 7
Suppose you are a banker and one of your export customer has booked a US$ 1,00,000 forward
sale contract for 2 months with you at the rate of ` 62.5200 and simultaneously you covered
yourself in the interbank market at ` 62.5900. However, on due date, after 2 months your
customer comes to you and requests for cancellation of the contract and also requests for
extension of the contract by one month. On this date quotation for US$ in the market was as
follows:
Spot ` 62.7200/62.6800
1 month forward ` 62.6400/62.7400
Determine the extension charges payable by the customer assuming exchange margin of 0.10%
on buying as well as selling.
Solution
Cancellation
First the original contract shall be cancelled at Spot Selling Rate as follows:
US$/` Spot Selling Rate ` 62.7200
Add: Margin @ 0.10% ` 0.06272
` 62.78272
Rounded off ` 62.7825
Bank buys US$ under original contract at ` 62.5200
Bank Sells at Spot Rate ` 62.7825
` 0.2625
Thus, total cancellation charges payable by the customer for US$ 1,00,000 is ` 26,250.
Rebooking
Forward US$/` Buying Rate ` 62.6400
Less: Margin @ 0.10% ` 0.06264
Net amount payable by customer per US$ ` 62.57736
Rounded off ` 62.5775
Extension before Due Date
In case any request to extend the contract is received before due date of maturity of forward
contract, first the original contract would be cancelled at the relevant forward rate as in case of
cancellation of contract before due date and shall be rebooked at the current forward rate of the
forward period.
Illustration 8
Suppose you as a banker entered into a forward purchase contract for US$ 50,000 on 5 th March
with an export customer for 3 months at the rate of ` 59.6000. On the same day you also covered
yourself in the market at ` 60.6025. However on 5 th May your customer comes to you and requests
extension of the contract to 5 thJuly. On this date (5 th May) quotation for US$ in the market is as
follows:
Spot ` 59.1300/1400 per US$

Spot/ 5th June ` 59.2300/2425 per US$
Spot/ 5thJuly ` 59.6300/6425 per US$
Assuming a margin 0.10% on buying and selling, determine the extension charges pay able by the
customer and the new rate quoted to the customer.
Solution
(a) Cancellation of Original Contract
The forward purchase contract shall be cancelled at the for the forward sale rate for delivery
June.
Interbank forward selling rate ` 59.2425
Add: Exchange Margin ` 0.0592
Rounded off, the rate applicable is ` 59.3000
Buying US$ under original contract at original rate ` 59.6000
Selling rate to cancel the contract ` 59.3000
Difference per US$ ` 00.3000
Exchange difference for US$ 50,000 payable to the customer is ` 15,000.
(b) Rate for booking new contract
The forward contract shall be rebooked with the delivery 15 th July as follows:
Forward buying rate (5th July) ` 59.6300
Less: Exchange Margin ` 0.0596
Rounded off to ` 59.5700
Late Extension
In case of late extension current rate prevailing on such date of delivery shall be applied. However,
before this delivery the provisions of Automatic Cancellation (discussed later on) shall be applied.
Automatic Cancellation
As per FEDAI Rule 6 a forward contract which remains overdue without any instructions from the
customers on or before due date shall stand automatically cancelled within 3 working days after
the maturity date. Though customer is liable to pay the exchange difference arising there from but
not entitled for the profit resulting from this cancellation.
For late delivery and extension after due date as mentioned above the contract shall be treated as
fresh contract and appropriate rates prevailing on such date shall be applicabl e as mentioned
below:
1. Late Delivery: In this case the relevant spot rate prevailing on the such date shall be
applicable.
2. Extension after Due Date: In this case relevant forward rate for the period desired shall be
applicable.
As mentioned earlier in both of above case cancellation charges shall be payable consisting of
following:
(i) Exchange Difference: The difference between Spot Rate of offsetting position (cancellation
rate) on the date of cancellation of contract after due date or 3 working days (whichever is
earlier) and original rate contracted for.
(ii) Swap Loss: The loss arises on account of offsetting its position created by early delivery as
bank normally covers itself against the position taken in the original forward contract. This
position is taken at the spot rate on the date of cancellation earliest forward rate of
offsetting position.
(iii) Interest on Outlay of Funds: Interest on the difference between the rate entered by the bank
in the interbank market and actual spot rate on the due date of contract of the opposite
position multiplied by the amount of foreign currency amount involved. This interest shall be
calculated for the period from the due date of maturity of the contract and the actual date of
cancellation of the contract or 3 working days whichever is later.
Please note in above in any case there is profit by the bank on any course of action same shall not
be passed on the customer as normally passed cancellation and extension on or before due dates.
Illustration 9
An importer booked a forward contract with his bank on 10th April for USD 2,00,000 due on 10th
June @ ` 64.4000. The bank covered its position in the market at ` 64.2800.
The exchange rates for dollar in the interbank market on 10th June and 13th June were:
10th June 13th June
Spot USD 1= ` 63.8000/8200 ` 63.6800/7200
Spot/June ` 63.9200/9500 ` 63.8000/8500
July ` 64.0500/0900 ` 63.9300/9900
August ` 64.3000/3500 ` 64.1800/2500
September ` 64.6000/6600 ` 64.4800/5600
Exchange Margin 0.10% and interest on outlay of funds @ 12%. The importer requested on 14th
June for extension of contract with due date on 10th August.
Rates rounded to 4 decimal in multiples of 0.0025.
On 10th June, Bank Swaps by selling spot and buying one month forward.
Calculate:
(i) Cancellation rate
(ii) Amount payable on $ 2,00,000
(iii) Swap loss
(iv) Interest on outlay of funds, if any
(v) New contract rate
(vi) Total Cost
Solution
(i) Cancellation Rate:
The forward sale contract shall be cancelled at Spot TT Purchase for $ prevailing on the
date of cancellation as follows:
$/ ` Market Buying Rate ` 63.6800
Less: Exchange Margin @ 0.10% ` 0.0636
` 63.6163

(ii) Amount payable on $ 2,00,000
Bank sells $2,00,000 @ ` 64.4000 ` 1,28,80,000
Bank buys $2,00,000 @ ` 63.6163 ` 1,27,23,260
Amount payable by customer ` 1,56,740
(iii) Swap Loss

On 10th June the bank does a swap sale of $ at market buying rate of ` 63.8000 and
forward purchase for June at market selling rate of ` 63.9500.
Bank buys at ` 63.9500
Bank sells at ` 63.8000
Amount payable by customer ` 0.1500
Swap Loss for $ 2,00,000 is ` = ` 30,000
(iv) Interest on Outlay of Funds

On 10th June, the bank receives delivery under cover contract at ` 64.2800 and sell spot at
` 63.8000.
Bank buys at ` 64.2800
Bank sells at ` 63.8000
Amount payable by customer ` 0.4800
Outlay for $ 2,00,000 is ` 96,000

Interest on ` 96,000 @ 12% for 3 days ` 96
(v) New Contract Rate
The contract will be extended at current rate
$/ ` Market forward selling Rate for August ` 64.2500
Add: Exchange Margin @ 0.10% ` 0.0643
` 64.3143

(vi) Total Cost
Cancellation Charges ` 1,56,740.00
Swap Loss ` 30,000.00
Interest ` 96.00
` 1,86,836.00
10.3 Non-deliverable Forward Contract

A cash-settled, short-term forward contract on a thinly traded or non-convertible foreign currency,
where the profit or loss at the time at the settlement date is calculated by taking the difference
between the agreed upon exchange rate and the sport rate at the time of settlement, for an agreed
upon notional amount of funds.
All NDFs have a fixing date and a settlement date. The fixing date is the date at which the
difference between the prevailing market exchange rate and the agreed upon exchange rate is
calculated. The settlement date is the date by which the payment of the difference is due to the
party receiving payment.
NDFs are commonly quoted for time periods of one month up to one year, and are normally quoted
and settled in U.S. dollars. They have become a popular instrument for corporations seeking to
hedge exposure to foreign currencies that are not internationally traded.
10.4 Rollover of Deliverable Forward Contract

Rollover of Deliverable Forward Contract is a Contract wherein, as an Exporter, you have no
Foreign Currency to Deliver at maturity and as an Importer you have no Local Currency to deliver
at maturity. As an Exporter or Importer you would like to rollover the contract which effectively
means spot cancellation and booking of new contract for later date.
The rationale behind the rollover is:
❖ Non receipt of Foreign Currency from client (export perspective),
❖ Shortage of local currencies (Import perspective) ,
❖ Non-agreement of payment with clients,
❖ Non availability of longer period forward contracts as normally forward contracts are
available maximum for one year and to hedge the exposure for the period more than one
roll over contract shall be used.
11. FUTURES CONTRACTS

A basic futures contract is very similar to the forward contract in its obligation and payoff profile.
There are some important distinctions between futures and forwards and swaps.
❖ The contract terms of futures are standardized. These encompass:
• Quantity and quality of the underlying;
• Time and place of delivery;
• Method of payment.
❖ Being standardized in nature credit risk as this is greatly reduced by marking the contract to
market on a daily basis with daily checking of position.
❖ Futures are smaller in contract size than forwards and swaps, which means that they are
available to a wider business market.
A financial futures contract is purchased or sold through a broker. It is a commitment to make or
take delivery of a specified financial instrument, or perform a particular service, at predetermin ed
date in the future. The price of the contract is established at the outset.
Distinction between Futures and Forward Contracts
There are major differences between the traditional forward contract and a futures contract. These
are tabulated below:
Feature Forward Contract Futures Contract

Amount Flexible Standard amount
Maturity Any valid business date Standard date. Usually one
agreed to by the two delivery date such as the second
parties Tuesday of every month
Furthest maturity Open 12 months forward
date
Currencies traded All currencies Majors
Cross rates Available in one contract; Usually requires two contracts
Multiple contracts avoided
Market-place Global network Regular markets − futures market
and exchanges
Price fluctuations No daily limit in many Daily price limit set by exchange
currencies
Risk Depends on counter party Minimal due to margin
requirements
Honouring of By taking and giving Mostly by a reverse transaction
contract delivery
Cash flow None until maturity date Initial margin plus ongoing
variation margin because of
market to market rate and final
payment on maturity date
Trading hours 24 hours a day 4 − 8 hours trading sessions
12. OPTION CONTRACTS

An option is a contract which has one or other of two key attributes:
• to buy (call option);
• or to sell (put option).
The purchaser is called the buyer or holder; the seller is called the writer or grantor. The premium
may be expressed as a percentage of the price per unit of the underlying.
The holder of an American option has the right to exercise the contract at any stage during the
period of the option, whereas the holder of a European option can exercise his right only at the
end of the period.
During or at the end of the contract period (depending on the type of the option)the holder can do
as he pleases. He can buy or sell (as the case may be) the underlying, let the con tract expire or
sell the option contract itself in the market.
Call Option: It is a contract that gives the buyer the right, but not the obligation, to buy a specified
number of units of commodity or a foreign currency from the seller of option at a fixed price on or
up to a specific date.
Put Option: It is a contract that gives the buyer the right, but not the obligation, to sell a specified
number of units of commodity or a foreign currency to a seller of option at a fixed price on or up to
a specific date.
Distinction between Options and Futures
There are certain fundamental differences between a futures and an option contract. Let us look
at the main comparative features given below:
Options Futures
(a) Only the seller (writer) is obliged to Both the parties are obligated to perform.
perform
(b) Premium is paid by the buyer to the seller No premium is paid by any party.
at the inception of the contract
(c) Loss is restricted while there is unlimited There is potential/risk for unlimited
gain potential for the option buyer. gain/loss for the futures buyer.
(d) An American option contract can be A futures contract has to be honoured by
exercised any time during its period by both the parties only on the date specified.
the buyer.
Options Vs Futures: Gain and Losses in Different Circumstances

Price Type of Position Held
Movement
Call buyer Long Call Seller Put Buyer Short Put Seller
Futures Futures
Position Position
Price rises Unlimited Unlimited Unlimited Limited Unlimited Limited
gain gain loss loss loss gain
Price falls Limited Unlimited Limited Unlimited Unlimited Unlimited
loss loss* gain gain* gain* loss*
Price Limited No gain or Limited Limited No Gain or Limited
unchanged loss loss gain loss loss gain
Note: Transaction Costs are ignored.

*Since the price of any commodity; share are financial instrument cannot go below zero, there is
technically a ‘limit’ to the gain/loss when the price falls. For practical purposes, this is largely
irrelevant.
13. SWAP CONTRACTS

Swaps are infinitely flexible. In technical terms they are a method of exchanging the underlying
economic basis of a debt or asset without affecting the underlying principal obligation on the debt
or asset.
A swap transaction commits the participants to exchange cash flows at specified intervals, which
are called payment or settlement dates. Cash flows are either fixed or calculated for specific dates
by multiplying the quantity of the underlying by specified reference rates or prices.
The vast majority of swaps are classified into the following groups:
❖ Interest rate;
❖ Currency;
❖ Commodity;
❖ Equity.
The notional principal (i.e. the face value of a security) on all these, except currency swaps, is
used to calculate the payment stream but not exchanged. Interim payments are usually netted -
the difference is paid by one party to the other.
Like forwards, the main users of swaps are large multinational banks or corporations. Swaps
create credit exposures and are individually designed to meet the risk-management objectives of
the participants.
13.1 Interest Rate Swaps
Interest Rate Swap has been covered in detail in the Chapter 12 of this Study Material. Please
refer the same from there.
13.2 Currency Swaps
It involve an exchange of liabilities between currencies. A currency swap can consist of three
stages:
❖ A spot exchange of principal - this forms part of the swap agreement as a similar effect can
be obtained by using the spot foreign exchange market.
❖ Continuing exchange of interest payments during the term of the swap - this represents a
series of forward foreign exchange contracts during the term of the swap contract. The
contract is typically fixed at the same exchange rate as the spot rate used at the outset of
the swap.
❖ Re-exchange of principal on maturity.
A currency swap has the following benefits:

❖ Treasurers can hedge currency risk.
❖ It can provide considerable cost savings. A strong borrower in the Japanese Yen market
may be interested in borrowing in the American USD markets where his credit rating may
not be as good as it is in Tokyo. Such a borrower could get a better US dollar rate by
raising funds first in the Tokyo market and then swapping Yen for US dollars.
❖ The swap market permits funds to be accessed in currencies, which may otherwise
command a high premium.
❖ It offers diversification of borrowings.
A more complex version of a currency swap is a currency coupon swap, which swaps a fixed -or-
floating rate interest payment in one currency for a floating rate payment in another. These are
also known as Circus Swaps.
In a currency swap the principal sum is usually exchanged:
❖ At the start;
❖ At the end;
❖ At a combination of both; or
❖ Neither.
Many swaps are linked to the issue of a Eurobond. An issuer offers a bond in a currency and
instrument where it has the greatest competitive advantage. It then asks the underwriter of the
bond to provide it with a swap to convert funds into the required type.
13.3 Commodity Swaps
It is a kind of series of Future Contracts involving settlement on the basis of notional amount over
multiple dates at predetermined specified reference prices or related commodities indices .
Although this swap strategy can be used for any commodity but primarily used in hedging oil price
risks.
13.4 Equity Swaps
An equity swap is an arrangement in which total return on equity or equity index in the form of
dividend and capital is exchanged with either a fixed or floating rate of interest.
14. STRATEGIES FOR EXPOSURE MANAGEMENT

A company’s attitude towards risk, financial strength, nature of business, vulnerability to adverse
movements, etc. shapes its exposure management strategies. There can be no single strategy
which is appropriate to all businesses. Four separate strategy options are feasible for exposure
management.
Exposure Management Strategies

14.1 Low Risk: Low Reward
This option involves automatic hedging of exposures in the forward market as soon as they arise,
irrespective of the attractiveness or otherwise of the forward rate. The merits of this approach are
that yields and costs of the transaction are known and there is little risk of cash flow
destabilization. Again, this option doesn't require any investment of management time or effort.
The negative side is that automatic hedging at whatever rates are available is hardly likely to result
into optimum costs. At least some management seems to prefer this strategy on the grounds that
an active management of exposures is not really their business. In the floating ra te era, currencies
outside their home countries, in terms of their exchange rate, have assumed the characteristics of
commodities. And business whose costs depend significantly on commodity prices can hardly
afford not to take views on the price of the commodity. Hence this does not seem to be an
optimum strategy.
14.2 Low Risk: Reasonable Reward
This strategy requires selective hedging of exposures whenever forward rates are attractive but
keeping exposures open whenever they are not. Successful pursuit of this strategy requires
quantification of expectations about the future and the rewards would depend upon the accuracy of
the prediction. This option is similar to an investment strategy of a combination of bonds and
equities with the proportion of the two components depending on the attractiveness of prices. In
foreign exchange exposure terms, hedged positions are similar to bonds (known costs or yields)
and unhedged ones to equities (uncertain returns).
14.3 High Risk: Low Reward
Perhaps the worst strategy is to leave all exposures unhedged. The risk of destabilization of cash
flows is very high. The merit is zero investment of managerial time or effort.
14.4 High Risk: High Reward
This strategy involves active trading in the currency market through continuous cancellations and
re-bookings of forward contracts. With exchange controls relaxed in India in recent times, a few of
the larger companies are adopting this strategy. In effect, this requires the trading function to
become a profit centre. This strategy, if it has to be adopted, should be done in full consciousness
of the risks.
15. CONCLUSION
Thus, on account of increased globalization of financial markets, risk management has gained
more importance. The benefits of the increased flow of capital between nations include a better
international allocation of capital and greater opportunities to diversify risk. However, globalization
of investment has meant new risks from exchange rates, political actions and increased
interdependence on financial conditions of different countries.
All these factors- increase in exchange rate risk, growth in international trade, globalization of
financial markets, increase in the volatility of exchange rates and growth of multinational and
transnational corporations- combine to make it imperative for today’s financial managers to study
the factors behind the risks of international trade and investment, and the methods of reducing
these risks.
TEST YOUR KNOWLEDGE

1. “Operations in foreign exchange market are exposed to a number of risks.” Discuss.
2. What do you mean by Nostro, Vostro and Loro Accounts?
Practical Questions
1. The price of a bond just before a year of maturity is $ 5,000. Its redemption value is $ 5,250
at the end of the said period. Interest is $ 350 p.a. The Dollar appreciates by 2% during the
said period. Calculate the rate of return.
2. ABN-Amro Bank, Amsterdam, wants to purchase ` 15 million against US$ for funding their
Nostro account with Canara Bank, New Delhi. Assuming the inter-bank, rates of US$ is `
51.3625/3700, what would be the rate Canara Bank would quote to ABN-Amro Bank?
Further, if the deal is struck, what would be the equivalent US$ amount.
3. XYZ Bank, Amsterdam, wants to purchase ` 25 million against £ for funding their Nostro
account and they have credited LORO account with Bank of London, London.
Calculate the amount of £’s credited. Ongoing inter-bank rates are per $, ` 61.3625/3700 &
per £, $ 1.5260/70.
4. ABC Ltd. of UK has exported goods worth Can $ 5,00,000 receivable in 6 months. The
exporter wants to hedge the receipt in the forward market. The following information is
available:
Spot Exchange Rate Can $ 2.5/£
Interest Rate in UK 12%
Interest Rate In Canada 15%
The forward rates truly reflect the interest rates differential. Find out the gain/loss to UK
exporter if Can $ spot rates (i) declines 2%, (ii) gains 4% or (iii) remains unch anged over
next 6 months.
5. On April 3, 2016, a Bank quotes the following:
Spot exchange Rate (US $ 1) INR 66.2525 INR 67.5945
2 months’ swap points 70 90
3 months’ swap points 160 186
In a spot transaction, delivery is made after two days.
Assume spot date as April 5, 2016.
Assume 1 swap point = 0.0001,
(i) ascertain swap points for 2 months and 15 days. (For June 20, 2016),
(ii) determine foreign exchange rate for June 20, 2016, and
(iii) compute the annual rate of premium/discount of US$ on INR, on an average rate.
6. JKL Ltd., an Indian company has an export exposure of JPY 10,000,000 receivable August
31, 2014. Japanese Yen (JPY) is not directly quoted against Indian Rupee.
The current spot rates are:
INR/US $ = ` 62.22
JPY/US$ = JPY 102.34
It is estimated that Japanese Yen will depreciate to 124 level and Indian Rupee to
depreciate against US $ to ` 65.
Forward rates for August 2014 are
INR/US $ = ` 66.50
Required:
(i) Calculate the expected loss, if the hedging is not done. How the position will change,
if the firm takes forward cover?
(ii) If the spot rates on August 31, 2014 are:
INR/US $= ` 66.25
Is the decision to take forward cover justified?
7. You sold Hong Kong Dollar 1,00,00,000 value spot to your customer at ` 5.70 & covered
yourself in London market on the same day, when the exchange rates were
US$ 1 = H.K.$ 7.5880 7.5920
Local inter bank market rates for US$ were
Spot US$ 1 = ` 42.70 42.85
Calculate cover rate and ascertain the profit or loss in the transaction. Ignore brokerage.
8. You, a foreign exchange dealer of your bank, are informed that your bank has sold a T.T.
on Copenhagen for Danish Kroner 10,00,000 at the rate of Danish Kroner 1 = ` 6.5150. You
are required to cover the transaction either in London or New York market. The rates on
that date are as under:
Mumbai-London ` 74.3000 ` 74.3200

Mumbai-New York ` 49.2500 ` 49.2625
London-Copenhagen DKK 11.4200 DKK 11.4350
New York-Copenhagen DKK 07.5670 DKK 07.5840
In which market will you cover the transaction, London or New York, and what will be the
exchange profit or loss on the transaction? Ignore brokerages.
9. On January 28, 2013 an importer customer requested a Bank to remit Singapore Dollar
(SGD) 2,500,000 under an irrevocable Letter of Credit (LC). However, due to unavoidable
factors, the Bank could effect the remittances only on February 4, 2013. The inter -bank
market rates were as follows:
January 28, 2013 February 4, 2013
US$ 1= ` 45.85/45.90 ` 45.91/45.97
GBP £ 1 = US$ 1.7840/1.7850 US$ 1.7765/1.7775
GBP £ 1 = SGD 3.1575/3.1590 SGD 3. 1380/3.1390
The Bank wishes to retain an exchange margin of 0.125%

Required:
How much does the customer stand to gain or lose due to the delay?
(Note: Calculate the rate in multiples of 0.0001)
10. Following are the details of cash inflows and outflows in foreign currency denominations of
MNP Co. an Indian export firm, which have no foreign subsidiaries:
Currency Inflow Outflow Spot rate Forward rate
US $ 4,00,00,000 2,00,00,000 48.01 48.82
French Franc (FFr) 2,00,00,000 80,00,000 7.45 8.12
U.K. £ 3,00,00,000 2,00,00,000 75.57 75.98
Japanese Yen 1,50,00,000 2,50,00,000 3.20 2.40
(i) Determine the net exposure of each foreign currency in terms of Rupees.
(ii) Are any of the exposure positions offsetting to some extent?
11. The following 2-way quotes appear in the foreign exchange market:
Spot 2-months forward
RS/US $ `46.00/`46.25 `47.00/`47.50
Required:
(i) How many US dollars should a firm sell to get ` 25 lakhs after 2 months?
(ii) How many Rupees is the firm required to pay to obtain US $ 2,00,000 in the spot
market?
(iii) Assume the firm has US $ 69,000 in current account earning no interest. ROI on
Rupee investment is 10% p.a. Should the firm encash the US $ now or 2 months
later?
12. Z Ltd. importing goods worth USD 2 million, requires 90 days to make the payment. The
overseas supplier has offered a 60 days interest free credit period and for additiona l credit
for 30 days an interest of 8% per annum.
The bankers of Z Ltd offer a 30 days loan at 10% per annum and their quote for foreign
exchange is as follows:
`
Spot 1 USD 56.50
60 days forward for 1 USD 57.10
90 days forward for 1 USD 57.50
You are required to evaluate the following options:

(i) Pay the supplier in 60 days, or
(ii) Avail the supplier's offer of 90 days credit.
13. Followings are the spot exchange rates quoted at three different forex markets:
USD/INR 48.30 in Mumbai
GBP/INR 77.52 in London
GBP/USD 1.6231 in New York
The arbitrageur has USD1,00,00,000. Assuming that there are no transaction costs, explain
whether there is any arbitrage gain possible from the quoted spot exchange rates.
14. The US dollar is selling in India at ` 55.50. If the interest rate for 6 months borrowing in
India is 10% per annum and the corresponding rate in USA is 4%.
(i) Do you expect that US dollar will be at a premium or at discount in the Indian Forex
Market?
(ii) What will be the expected 6-months forward rate for US dollar in India? and
(iii) What will be the rate of forward premium or discount?
15. In March, 2009, the Multinational Industries make the following assessment of dollar
rates per British pound to prevail as on 1.9.2009:
$/Pound Probability
1.60 0.15
1.70 0.20
1.80 0.25
1.90 0.20
2.00 0.20
(i) What is the expected spot rate for 1.9.2009?
(ii) If, as of March, 2009, the 6-month forward rate is $ 1.80, should the firm sell forward
its pound receivables due in September, 2009?
16. An importer customer of your bank wishes to book a forward contract with your bank on 3 rd
September for sale to him of SGD 5,00,000 to be delivered on 30 th October.
The spot rates on 3 rd September are USD 49.3700/3800 and USD/SGD 1.7058/68. The
swap points are:
USD /` USD/SGD
Spot/September 0300/0400 1st month forward 48/49
Spot/October 1100/1300 2nd month forward 96/97
Spot/November 1900/2200 3rd month forward 138/140
Spot/December 2700/3100
Spot/January 3500/4000
Calculate the rate to be quoted to the importer by assuming an exchange margin of

paisa.
17. A company operating in Japan has today effected sales to an Indian company, the payment
being due 3 months from the date of invoice. The invoice amount is 108 lakhs yen. At
today's spot rate, it is equivalent to ` 30 lakhs. It is anticipated that the exchange rate will
decline by 10% over the 3 months period and in order to protect the yen payments, the
importer proposes to take appropriate action in the foreign exchange market. The 3 months
forward rate is presently quoted as 3.3 yen per rupee. You are required to calculate the
expected loss and to show how it can be hedged by a forward contract.
18. ABC Co. have taken a 6 month loan from their foreign collaborators for US Dollars 2
millions. Interest payable on maturity is at LIBOR plus 1.0%. Current 6-month LIBOR is 2%.
Enquiries regarding exchange rates with their bank elicits the following information:
Spot USD 1 ` 48.5275
6 months forward ` 48.4575
(i) What would be their total commitment in Rupees, if they enter into a forward
contract?
(ii) Will you advise them to do so? Explain giving reasons.
19. Excel Exporters are holding an Export bill in United States Dollar (USD) 1,00,000 due 60
days hence. They are worried about the falling USD value which is currently at ` 45.60 per
USD. The concerned Export Consignment has been priced on an Exchange rate of ` 45.50
per USD. The Firm’s Bankers have quoted a 60-day forward rate of ` 45.20.
Calculate:
(i) Rate of discount quoted by the Bank
(ii) The probable loss of operating profit if the forward sale is agreed to.
20. In International Monetary Market an international forward bid for December, 15 on pound
sterling is $ 1.2816 at the same time that the price of IMM sterling future for delivery on
December, 15 is $ 1.2806. The contract size of pound sterling is £ 62,500. How could the
dealer use arbitrage in profit from this situation and how much profit is earned?
21. An Indian importer has to settle an import bill for $ 1,30,000. The exporter has given the
Indian exporter two options:
(i) Pay immediately without any interest charges.
(ii) Pay after three months with interest at 5 percent per annum.
The importer's bank charges 15 percent per annum on overdrafts. The exchange rates in
the market are as follows:
Spot rate (` /$) : 48.35 /48.36
3-Months forward rate (`/$) : 48.81 /48.83
The importer seeks your advice. Give your advice.
22. DEF Ltd. has imported goods to the extent of US$ 1 crore. The payment terms are 60 days
interest-free credit. For additional credit of 30 days, interest at the rate of 7.75% p.a. will be
charged.
The banker of DEF Ltd. has offered a 30 days loan at the rate of 9.5% p.a. Their quote for
the foreign exchange is as follows:
Spot rate INR/US$ 62.50
60 days forward rate INR/US$ 63.15
90 days forward rate INR/US$ 63.45
Which one of the following options would be better?
(i) Pay the supplier on 60th day and avail bank loan for 30 days.
(ii) Avail the supplier's offer of 90 days credit.
23. A company is considering hedging its foreign exchange risk. It has made a purchase on 1st
July, 2016 for which it has to make a payment of US$ 60,000 on December 31, 2016. The
present exchange rate is 1 US $ = ` 65. It can purchase forward 1 $ at ` 64. The company
will have to make an upfront premium @ 2% of the forward amount purchased. The cost of
funds to the company is 12% per annum.
In the following situations, compute the profit/loss the company will make if it hedges its
foreign exchange risk with the exchange rate on 31 st December, 2016 as:
(i) ` 68 per US $.
(ii) ` 62 per US $.
(iii) ` 70 per US $.
(iv) ` 65 per US $.
24. Following information relates to AKC Ltd. which manufactures some parts of an electronics
device which are exported to USA, Japan and Europe on 90 days credit terms.
Cost and Sales information:
Japan USA Europe
Variable cost per unit `225 `395 `510
Export sale price per unit Yen 650 US$10.23 Euro 11.99
Receipts from sale due in 90 Yen 78,00,000 US$1,02,300 Euro 95,920
days
Foreign exchange rate information:
Yen/` US$/` Euro/`
Spot market 2.417-2.437 0.0214-0.0217 0.0177-0.0180
3 months forward 2.397-2.427 0.0213-0.0216 0.0176-0.0178
3 months spot 2.423-2.459 0.02144-0.02156 0.0177-0.0179
Advise AKC Ltd. by calculating average contribution to sales ratio whether it should hedge
it’s foreign currency risk or not.
25. EFD Ltd. is an export business house. The company prepares invoice in customers'
currency. Its debtors of US$. 10,000,000 is due on April 1, 2015.
Market information as at January 1, 2015 is:
Exchange rates US$/INR Currency Futures US$/INR
Spot 0.016667 Contract size: ` 24,816,975
1-month forward 0.016529 1-month 0.016519
3-months forward 0.016129 3-month 0.016118
Initial Margin Interest rates in India
1-Month ` 17,500 6.5%
3-Months ` 22,500 7%
On April 1, 2015 the spot rate US$/INR is 0.016136 and currency future rate is 0.016134.
Which of the following methods would be most advantageous to EFD Ltd?
(i) Using forward contract
(ii) Using currency futures
(iii) Not hedging the currency risk
26. Spot rate 1 US $ = ` 48.0123
180 days Forward rate for 1 US $ = ` 48.8190
Annualised interest rate for 6 months – Rupee = 12%
Annualised interest rate for 6 months – US $ = 8%
Is there any arbitrage possibility? If yes how an arbitrageur can take advantage of the
situation, if he is willing to borrow ` 40,00,000 or US $83,312.
27. Given the following information:
Exchange rate – Canadian dollar 0.665 per DM (spot)
Canadian dollar 0.670 per DM (3 months)
Interest rates – DM 7% p.a.
Canadian Dollar – 9% p.a.
What operations would be carried out to take the possible arbitrage gains?
28. An Indian exporting firm, Rohit and Bros., would be covering itself against a likely
depreciation of pound sterling. The following data is given:
Receivables of Rohit and Bros : £500,000
Spot rate : ` 56.00/£
Payment date : 3-months
3 months interest rate : India : 12 per cent per annum
: UK : 5 per cent per annum
What should the exporter do?
29. An exporter is a UK based company. Invoice amount is $3,50,000. Credit period is three
months. Exchange rates in London are :
Spot Rate ($/£) 1.5865 – 1.5905
3-month Forward Rate ($/£) 1.6100 – 1.6140
Rates of interest in Money Market :
Deposit Loan
$ 7% 9%
£ 5% 8%
Compute and show how a money market hedge can be put in place. Compare and contrast
the outcome with a forward contract.
30. The rate of inflation in India is 8% per annum and in the U.S.A. it is 4%. The current spot
rate for USD in India is ` 46. What will be the expected rate after 1 year and after 4 years
applying the Purchasing Power Parity Theory.
31. On April 1, 3 months interest rate in the UK £ and US $ are 7.5% and 3.5% per annum
respectively. The UK £/US $ spot rate is 0.7570. What would be the forward rate for US $
for delivery on 30 th June?
32. An importer requests his bank to extend the forward contract for US$ 20,000 which is due
for maturity on 30 th October, 2010, for a further period of 3 months. He agrees to pay the
required margin money for such extension of the contract.
Contracted Rate – US$ 1= ` 42.32
The US Dollar quoted on 30-10-2010:-
Spot – 41.5000/41.5200
3 months’ Premium -0.87% /0.93%
Margin money for buying and selling rate is 0.075% and 0.20% respectively.
Compute:
(i) The cost to the importer in respect of the extension of the forward contract, and
(ii) The rate of new forward contract.
33. XYZ, an Indian firm, will need to pay JAPANESE YEN (JY) 5,00,000 on 30 th June. In order
to hedge the risk involved in foreign currency transaction, the firm is considering two
alternative methods i.e. forward market cover and currency option contract.
On 1st April, following quotations (JY/INR) are made available:
Spot 3 months forward
1.9516/1.9711. 1.9726./1.9923
The prices for forex currency option on purchase are as follows:
Strike Price JY 2.125
Call option (June) JY 0.047
Put option (June) JY 0.098
For excess or balance of JY covered, the firm would use forward rate as future spot rate.
You are required to recommend cheaper hedging alternative for XYZ.
34. ABC Technologic is expecting to receive a sum of US$ 4,00,000 after 3 months. The
company decided to go for future contract to hedge against the risk. The standard size of
future contract available in the market is $1000. As on date spot and futures $ contract are
quoting at ` 44.00 &` 45.00 respectively. Suppose after 3 months the company closes out
its position futures are quoting at ` 44.50 and spot rate is also quoting at ` 44.50. You are
required to calculate effective realization for the company while selling the receivable. Also
calculate how company has been benefitted by using the future option.
35. Gibralater Limited has imported 5000 bottles of shampoo at landed cost in Mumbai, of
US $ 20 each. The company has the choice for paying for the goods immediately or in 3
months’ time. It has a clean overdraft limited where 14% p.a. rate of interest is charged.
Calculate which of the following method would be cheaper to Gibralter Limited.
(i) Pay in 3 months’ time with interest @ 10% p.a. and cover risk forward for 3 months.
(ii) Settle now at a current spot rate and pay interest of the over draft for 3 months.
The rates are as follows:
Mumbai ` /$ spot : 60.25-60.55
3 months swap points : 35/25

36. An American firm is under obligation to pay interests of Can$ 1010000 and Can$ 705000 on
31st July and 30th September respectively. The Firm is risk averse and its policy is to hedge
the risks involved in all foreign currency transactions. The Finance Manager of the firm is
thinking of hedging the risk considering two methods i.e. fixed forward or option contracts.
It is now June 30. Following quotations regarding rates of exchange, US$ per Can$, from
the firm’s bank were obtained:
Spot 1 Month Forward 3 Months Forward
0.9284-0.9288 0.9301 0.9356
Price for a Can$ /US$ option on a U.S. stock exchange (cents per Can$, payable on
purchase of the option, contract size Can$ 50000) are as follows:
Strike Price Calls Puts
(US$/Can$) July Sept. July Sept.
0.93 1.56 2.56 0.88 1.75
0.94 1.02 NA NA NA
0.95 0.65 1.64 1.92 2.34
According to the suggestion of finance manager if options are to be used, one month option
should be bought at a strike price of 94 cents and three month option at a strike price of 95
cents and for the remainder uncovered by the options the firm would bear the risk itself. For
this, it would use forward rate as the best estimate of spot. Transaction costs are ignored.
Recommend, which of the above two methods would be appropriate for the America n
firm to hedge its foreign exchange risk on the two interest payments.
37. Zaz plc, a UK Company is in the process of negotiating an order amounting €2.8 million with
a large German retailer on 6 month’s credit. If successful, this will be first time for Zaz has
exported goods into the highly competitive German Market. The Zaz is considering following
3 alternatives for managing the transaction risk before the order is finalized.
(a) Mr. Peter the Marketing head has suggested that in order to remove trans action risk
completely Zaz should invoice the German firm in Sterling using the current €/£
average spot rate to calculate the invoice amount.
(b) Mr. Wilson, CE is doubtful about Mr. Peter’s proposal and suggested an alternative
of invoicing the German firm in € and using a forward exchange contract to hedge
the transaction risk.
(c) Ms. Karen, CFO is agreed with the proposal of Mr. Wilson to invoice the German first
in €, but she is of opinion that Zaz should use sufficient 6 month sterling further
contracts (to the nearest whole number) to hedge the transaction risk.
Following data is available
Spot Rate € 1.1960 - €1.1970/£
6 months forward points 0.60 – 0.55 Euro Cents.
6 month further contract is currently trading at € 1.1943/£
6 month future contract size is £62,500
After 6 month Spot rate and future rate € 1.1873/£
You are required to
(a) Calculate (to the nearest £) the £ receipt for Zaz plc, under each of 3 above
proposals.
(b) In your opinion which alternative you consider to be most appropriate.
38. Columbus Surgicals Inc. is based in US, has recently imported surgical raw materials from
the UK and has been invoiced for £ 480,000, payable in 3 months. It has also exported
surgical goods to India and France.
The Indian customer has been invoiced for £ 138,000, payable in 3 months, and the French
customer has been invoiced for € 590,000, payable in 4 months.
Current spot and forward rates are as follows:

£ / US$
Spot: 0.9830 – 0.9850
Three months forward: 0.9520 – 0.9545
US$ / €
Spot: 1.8890 – 1.8920
Four months forward: 1.9510 – 1.9540
Current money market rates are as follows:
UK: 10.0% – 12.0% p.a.
France: 14.0% – 16.0% p.a.
USA: 11.5% – 13.0% p.a.
You as Treasury Manager are required to show how the company can hedge its foreign
exchange exposure using Forward markets and Money markets hedge and suggest which the
best hedging technique is.
39. XYZ Ltd. a US firm will need £ 3,00,000 in 180 days. In this connection, the following
information is available:
Spot rate 1 £ = $ 2.00
180 days forward rate of £ as of today = $1.96
Interest rates are as follows:
U.K. US
180 days deposit rate 4.5% 5%
180 days borrowing rate 5% 5.5%
A call option on £ that expires in 180 days has an exercise price of $ 1.97 and a premium of
$ 0.04.
XYZ Ltd. has forecasted the spot rates 180 days hence as below:
Future rate Probability
$ 1.91 25%
$ 1.95 60%
$ 2.05 15%
Which of the following strategies would be most preferable to XYZ Ltd.?
(a) A forward contract;
(b) A money market hedge;
(c) An option contract;

(d) No hedging.
Show calculations in each case
40. A Ltd. of U.K. has imported some chemical worth of USD 3,64,897 from one of the U.S.
suppliers. The amount is payable in six months time. The relevant spot and forward rates
are:
Spot rate USD 1.5617-1.5673
6 months’ forward rate USD 1.5455 –1.5609
The borrowing rates in U.K. and U.S. are 7% and 6% respectively and the deposit rates are
5.5% and 4.5% respectively.
Currency options are available under which one option contract is for GBP 12,500. The
option premium for GBP at a strike price of USD 1.70/GBP is USD 0.037 (call option) and
USD 0.096 (put option) for 6 months period.
The company has 3 choices:
(i) Forward cover
(ii) Money market cover, and
(iii) Currency option
Which of the alternatives is preferable by the company?
41. Nitrogen Ltd, a UK company is in the process of negotiating an order amounting to €4 million
with a large German retailer on 6 months credit. If successful, this will be the first time that
Nitrogen Ltd has exported goods into the highly competitive German market. The following
three alternatives are being considered for managing the transaction risk before the order is
finalized.
(i) Invoice the German firm in Sterling using the current exchange rate to calculate the
invoice amount.
(ii) Alternative of invoicing the German firm in € and using a forward foreign exchange
contract to hedge the transaction risk.
(iii) Invoice the German first in € and use sufficient 6 months sterling future contracts (to
the nearly whole number) to hedge the transaction risk.
Following data is available:
Spot Rate € 1.1750 - €1.1770/£
6 months forward premium 0.55-0.60 Euro Cents
6 months future contract is currently trading at €1.1760/£

6 months future contract size is £62500
Spot rate and 6 months future rate €1.1785/£
Required:
(a) Calculate to the nearest £ the receipt for Nitrogen Ltd, under each of the three
proposals.
(b) In your opinion, which alternative would you consider to be the most appropriate and
the reason thereof.
42. Sun Ltd. is planning to import equipment from Japan at a cost of 3,400 lakh yen. The company
may avail loans at 18 percent per annum with quarterly rests with which it can import the
equipment. The company has also an offer from Osaka branch of an India based bank extending
credit of 180 days at 2 percent per annum against opening of an irrecoverable letter of credit.
Additional information:
Present exchange rate ` 100 = 340 yen
180 day’s forward rate ` 100 = 345 yen
Commission charges for letter of credit at 2 per cent per 12 months.
Advice the company whether the offer from the foreign branch should be accepted.
43. NP and Co. has imported goods for US $ 7,00,000. The amount is payable after three
months. The company has also exported goods for US $ 4,50,000 and this amount is
receivable in two months. For receivable amount a forward contract is already taken at `
48.90.
The market rates for Rupee and Dollar are as under:
Spot ` 48.50/70
Two months 25/30 points
Three months 40/45 points
The company wants to cover the risk and it has two options as under :
(A) To cover payables in the forward market and
(B) To lag the receivables by one month and cover the risk only for the net amount. No
interest for delaying the receivables is earned. Evaluate both the options if the cost
of Rupee Funds is 12%. Which option is preferable?
44. A customer with whom the Bank had entered into 3 months’ forward purchase contract for
Swiss Francs 10,000 at the rate of ` 27.25 comes to the bank after 2 months and requests
cancellation of the contract. On this date, the rates, prevailing, are:
Spot CHF 1 = ` 27.30 27.35

One month forward ` 27.45 27.52
What is the loss/gain to the customer on cancellation?
45. A bank enters into a forward purchase TT covering an export bill for Swiss Francs 1,00,000
at ` 32.4000 due 25 th April and covered itself for same delivery in the local inter bank
market at ` 32.4200. However, on 25 th March, exporter sought for cancellation of the
contract as the tenor of the bill is changed.
In Singapore market, Swiss Francs were quoted against dollars as under:
Spot USD 1 = Sw. Fcs. 1.5076/1.5120
One month forward 1.5150/ 1.5160
Two months forward 1.5250 / 1.5270
Three months forward 1.5415/ 1.5445
and in the interbank market US dollars were quoted as under:
Spot USD 1 = ` 49.4302/.4455
Spot / April 4100/.4200
Spot/May .4300/.4400
Spot/June .4500/.4600
Calculate the cancellation charges, payable by the customer if exchange margin required by
the bank is 0.10% on buying and selling.
46. Your forex dealer had entered into a cross currency deal and had sold US $ 10,00,000
against EURO at US $ 1 = EURO 1.4400 for spot delivery.
However, later during the day, the market became volatile and the dealer in compliance
with his management’s guidelines had to square – up the position when the quotations
were:
Spot US $ 1 INR 31.4300/4500
1 month margin 25/20
2 months margin 45/35
Spot US $ 1 EURO 1.4400/4450
1 month forward 1.4425/4490
2 months forward 1.4460/4530
What will be the gain or loss in the transaction?
47. You have following quotes from Bank A and Bank B:
Bank A Bank B
SPOT USD/CHF 1.4650/55 USD/CHF 1.4653/60
3 months 5/10
6 months 10/15
SPOT GBP/USD 1.7645/60 GBP/USD 1.7640/50
3 months 25/20
6 months 35/25
Calculate :
(i) How much minimum CHF amount you have to pay for 1 Million GBP spot?
(ii) Considering the quotes from Bank A only, for GBP/CHF what are the Implied Swap
points for Spot over 3 months?
48. M/s Omega Electronics Ltd. exports air conditioners to Germany by importing all the
components from Singapore. The company is exporting 2,400 units at a price of Euro 500
per unit. The cost of imported components is S$ 800 per unit. The fixed cost and other
variables cost per unit are ` 1,000 and ` 1,500 respectively. The cash flows in Foreign
currencies are due in six months. The current exchange rates are as follows:
`/Euro 51.50/55
`/S$ 27.20/25
After six months the exchange rates turn out as follows:
`/Euro 52.00/05
`/S$ 27.70/75
(A) You are required to calculate loss/gain due to transaction exposure.
(B) Based on the following additional information calculate the loss/gain due to
transaction and operating exposure if the contracted price of air conditioners is
` 25,000 :
(i) the current exchange rate changes to
`/Euro 51.75/80
`/S$ 27.10/15
(ii) Price elasticity of demand is estimated to be 1.5
(iii) Payments and receipts are to be settled at the end of six months.
49. Your bank’s London office has surplus funds to the extent of USD 5,00, 000/- for a period of
3 months. The cost of the funds to the bank is 4% p.a. It proposes to invest these funds in
London, New York or Frankfurt and obtain the best yield, without any exchange risk to the
bank. The following rates of interest are available at the three centres for investment of
domestic funds there at for a period of 3 months.
London 5 % p.a.
New York 8% p.a.
Frankfurt 3% p.a.
The market rates in London for US dollars and Euro are as under:
London on New York
Spot 1.5350/90
1 month 15/18
2 month 30/35
3 months 80/85
London on Frankfurt
Spot 1.8260/90
1 month 60/55
2 month 95/90
3 month 145/140
At which centre, will be investment be made & what will be the net gain (to the nearest
pound) to the bank on the invested funds?
50. Drilldip Inc. a US based company has a won a contract in India for drilling oil field. The
project will require an initial investment of ` 500 crore. The oil field along with equipments
will be sold to Indian Government for ` 740 crore in one year time. Since the Indian
Government will pay for the amount in Indian Rupee (`) the company is worried about
exposure due exchange rate volatility.
(a) Construct a swap that will help the Drilldip to reduce the exchange rate risk.
(b) Assuming that Indian Government offers a swap at spot rate which is 1US$ = ` 50 in
one year, then should the company should opt for this option or should it just do
nothing. The spot rate after one year is expected to be 1US$ = ` 54. Further you
may also assume that the Drilldip can also take a US$ loan at 8% p.a.
51. You as a dealer in foreign exchange have the following position in Swiss Francs on
31st October, 2009:
Swiss Francs
Balance in the Nostro A/c Credit 1,00,000
Opening Position Overbought 50,000
Purchased a bill on Zurich 80,000
Sold forward TT 60,000
Forward purchase contract cancelled 30,000
Remitted by TT 75,000
Draft on Zurich cancelled 30,000
What steps would you take, if you are required to maintain a credit Balance of Swiss Francs
30,000 in the Nostro A/c and keep as overbought position on Swiss Francs 10,000?
ANSWERS/ SOLUTIONS
2. Please refer paragraph 2.
1. Here we can assume two cases (i) If investor is US investor then there will be no impact of
appreciation in $. (ii) If investor is from any other nation other than US say Indian then there
will be impact of $ appreciation on his returns.
First we shall compute return on bond which will be common for both investors.
(Price at end - Price at begining)+ Interest
Return =
Price at begining
(5250 − 5000) + 350
=
5000
250 + 350
= =0.12 say 12%
5000
(i) For US investor the return shall be 12% and there will be no impact of appreciation in $.
(ii) If $ appreciate by 2% then return for non-US investor shall be:
Return x 1.02 = 0.12 x 1.02=0.1224 i.e. 12.24%
Alternatively, it can also be considered that $ appreciation will be applicable to the amount
of principal as well. The answer therefore could also be
(1+0.12)(1+0.02) -1 =1.12X1.02 - 1 = 0.1424 i.e. 14.24%

2. Here Canara Bank shall buy US$ and credit ` to Vostro account of ABN-Amro Bank.
Canara Bank’s buying rate will be based on the Inter-bank Buying Rate (as this is the rate
at which Canara Bank can sell US$ in the Interbank market)
Accordingly, the Interbank Buying Rate of US$ will be ` 51.3625 (lower of two) i.e. (1/51.3625) =
$ 0.01947/`
Equivalent of US$ for ` 15 million at this rate will be
15,000,000
= = US$ 2,92,041.86
51.3625
or = 15,000,000 x $ 0.01947 = US$ 2,92,050
3. To purchase Rupee, XYZ Bank shall first sell £ and purchase $ and then sell $ to purchase
Rupee. Accordingly, following rate shall be used:
(£/`)ask
The available rates are as follows:
($/£)bid = $1.5260
($/£)ask = $1.5270
(`/$)bid = ` 61.3625
(`/$)ask = ` 61.3700
From above available rates we can compute required rate as follows:
(£/`)ask = (£/$)ask x ($/`)ask
= (1/1.5260) x (1/61.3625)
= £ 0.01068 or £ 0.0107
Thus, amount of £ to be credited
= ` 25,000,000 x £ 0.0107
= £ 267,500
2.50 (1 + 0.075)
4. Forward Rate = = Can$ 2.535/£
(1 + 0.060)
(i) If spot rate decline by 2%

Spot Rate = Can$ 2.50 x 1.02 = Can$ 2.55/£
£
£ receipt as per Forward Rate (Can $ 5,00,000/ Can$ 2.535) 1,97,239
£ receipt as per Spot Rate (Can $ 5,00,000/ Can$ 2.55) 1,96,078

Gain due to forward contract 1,161
(ii) If spot rate gains by 4%
Spot Rate = Can$ 2.50 x 0.96 = Can$ 2.40/£
£
Loss due to forward contract 11,094
(iii) If spot rate remains unchanged
£
Loss due to forward contract 2,761
5. (i) Swap Points for 2 months and 15 days

Bid Ask
Swap Points for 2 months (a) 70 90
Swap Points for 3 months (b) 160 186
Swap Points for 30 days (c) = (b) – (a) 90 96
Swap Points for 15 days (d) = (c)/2 45 48
Swap Points for 2 months & 15 days (e) = (a) + (d) 115 138
(ii) Foreign Exchange Rates for 20 th June 2016
Bid Ask
Spot Rate (a) 66.2525 67.5945
Swap Points for 2 months & 15 days (b) 0.0115 0.0138
66.2640 67.6083
(iii) Annual Rate of Premium
Bid Ask
Spot Rate (a) 66.2525 67.5945
Foreign Exchange Rates for 66.2640 67.6083
20 th June 2016 (b)
Premium (c) 0.0115 0.0138
Total (d) = (a) + (b) 132.5165 135.2028
Average (d) / 2 66.2583 67.6014
Premium 0.0115 12 0.0138 12
 × 100  × 100
66.2583 2.5 67.6014 2.5
= 0.0833% = 0.0980%
6. Since the direct quote for ¥ and ` is not available it will be calculated by cross exchange
rate as follows:
`/$ x $/¥ = `/¥
62.22/102.34 = 0.6080
Spot rate on date of export 1¥ = ` 0.6080
Expected Rate of ¥ for August 2014 = ` 0.5242 (` 65/¥124)
Forward Rate of ¥ for August 2014 = ` 0.6026 (` 66.50/¥110.35)
(i) Calculation of expected loss without hedging
Value of export at the time of export (` 0.6080 x ¥10,000,000) ` 60,80,000

Estimated payment to be received on Aug. 2014 (` 0.5242 x ` 52,42,000
¥10,000,000)
Loss ` 8,38,000
Hedging of loss under Forward Cover
` Value of export at the time of export (` 0.6080 x ` 60,80,000

¥10,000,000)
Payment to be received under Forward Cover (` 0.6026 x ` 60,26,000
¥10,000,000)
Loss ` 54,000
By taking forward cover loss is reduced to ` 54,000.
(ii) Actual Rate of ¥ on August 2014 = ` 0.5977 (` 66.25/¥110.85)
Value of export at the time of export (` 0.6080 x ¥10,000,000) ` 60,80,000

Estimated payment to be received on Aug. 2014 (` 0.5977 x ` 59,77,000
¥10,000,000)
Loss ` 1,03,000
The decision to take forward cover is still justified.

7. The bank (Dealer) covers itself by buying from the market at market selling rate.
Rupee – Dollar selling rate = ` 42.85
Dollar – Hong Kong Dollar = HK $ 7.5880
Rupee – Hong Kong cross rate = ` 42.85 / 7.5880
= ` 5.6471
Profit / Loss to the Bank
Amount received from customer (1 crore  5.70) ` 5,70,00,000
Amount paid on cover deal (1 crore  5.6471) ` 5,64,71,000
Profit to Bank ` 5,29,000
8. Amount realized on selling Danish Kroner 10,00,000 at ` 6.5150 per Kroner = ` 65,15,000.
Cover at London:
Bank buys Danish Kroner at London at the market selling rate.
Pound sterling required for the purchase (DKK 10,00,000 ÷ DKK 11.4200) = GBP 87,565.67
Bank buys locally GBP 87,565.67 for the above purchase at the market selling rate of
` 74.3200.
The rupee cost will be = ` 65,07,88
Profit (` 65,15,000 - ` 65,07,881) = ` 7,119
Cover at New York:
Bank buys Kroners at New York at the market selling rate.
Dollars required for the purchase of Danish Kroner (DKK10,00,000 ÷ 7.5670) = USD
1,32,152.77
Bank buys locally USD 1,32,152.77 for the above purchase at the market selling rate of
` 49.2625.
The rupee cost will be = ` 65,10,176.
Profit (` 65,15,000 - ` 65,10,176) = ` 4,824
The transaction would be covered through London which gets the maximum profit of
` 7,119 or lower cover cost at London Market by (` 65,10,176 - ` 65,07,881) = ` 2,295
9. On January 28, 2013 the importer customer requested to remit SGD 25 lakhs.
To consider sell rate for the bank:
US $ = `45.90
Pound 1 = US$ 1.7850
Pound 1 = SGD 3.1575
` 45.90 * 1.7850
Therefore, SGD 1 =
SGD 3.1575
SGD 1 = `25.9482
Add: Exchange margin (0.125%) ` 0.0324
` 25.9806
On February 4, 2013 the rates are
US $ = ` 45.97
Pound 1 = US$ 1.7775
Pound 1 = SGD 3.1380
` 45.97 * 1.7775
Therefore, SGD 1 =
SGD 3.1380
SGD 1 = ` 26.0394
Add: Exchange margin (0.125%) ` 0.0325
` 26.0719
Hence, loss to the importer
= SGD 25,00,000 (`26.0719 – `25.9806)= `2,28,250
10. (i) Net exposure of each foreign currency in Rupees
Inflow Outflow Net Inflow Spread Net Exposure

(Millions) (Millions) (Millions) (Millions)
US$ 40 20 20 0.81 16.20
FFr 20 8 12 0.67 8.04
UK£ 30 20 10 0.41 4.10
Japan Yen 15 25 -10 -0.80 8.00
(ii) The exposure of Japanese yen position is being offset by a better forward rate
11. (i) US $ required to get ` 25 lakhs after 2 months at the Rate of ` 47/$
` 25,00,000
∴ = US $ 53191.489
` 47
(ii) ` required to get US$ 2,00,000 now at the rate of ` 46.25/$
 US $ 200,000 × ` 46.25 = ` 92,50,000
(iii) Encashing US $ 69000 Now Vs 2 month later
Proceed if we can encash in open mkt $ 69000 × `46 = ` 31,74,000
Opportunity gain
10 2
= 31,74,000   ` 52,900
100 12
Likely sum at end of 2 months 32,26,900
Proceeds if we can encash by forward rate :
$ 69000 × `47.00 32,43,000
It is better to encash the proceeds after 2 months and get opportunity gain.
12. (i) Pay the supplier in 60 days
If the payment is made to supplier in 60 days the ` 57.10

applicable forward rate for 1 USD
Payment Due USD 2,000,000
Outflow in Rupees (USD 2000000 × `57.10) `114,200,000
Add: Interest on loan for 30 days@10% p.a. ` 9,51,667
Total Outflow in ` `11,51,51,667
(ii) Availing supplier’s offer of 90 days credit
Amount Payable USD 2,000,000

Add: Interest on credit period for 30 days@8% p.a. USD 13,333
Total Outflow in USD USD 2,013,333
Applicable forward rate for 1 USD `57.50
Total Outflow in ` (USD 2,013,333 ×`57.50) `115,766,648
Alternative 1 is better as it entails lower cash outflow.

13. The arbitrageur can proceed as stated below to realize arbitrage gains.
(i) Buy ` from USD 10,000,000 At Mumbai 48.30 × 10,000,000 `483,000,000
` 483,000,000
(ii) Convert these ` to GBP at London ( ) GBP 6,230,650.155
` 77.52
(iii) Convert GBP to USD at New York GBP 6,230,650.155 × 1.6231 USD 10,112,968.26
There is net gain of USD 10,112968.26 less USD 10,000,000 i.e. USD 112,968.26
14. (i) Under the given circumstances, the USD is expected to quote at a premium in India
as the interest rate is higher in India.
(ii) Calculation of the forward rate:
1 + R h F1
=
1 + R f Eo
Where: Rh is home currency interest rate, R f is foreign currency interest rate, F 1 is
end of the period forward rate, and E o is the spot rate.
1 + ( 0.10/2 ) F1
Therefore =
1 + ( 0.04 / 2 ) 55.50
1 + 0.05 F1
=
1 + 0.02 55.50
1.05
or  55.50 = F1
1.02
58.275
or = F1
1.02
or F1 = `57.13
(iii) Rate of premium:
57.13 - 55.50 12
  100 = 5.87%
55.50 6
15. (i) Calculation of expected spot rate for September, 2009:
$ for £ Probability Expected $/£
(1) (2) (1) × (2) = (3)
1.60 0.15 0.24
1.70 0.20 0.34
1.80 0.25 0.45
1.90 0.20 0.38
2.00 0.20 0.40
1.00 EV = 1.81
Therefore, the expected spot value of $ for £ for September, 2009 would be $ 1.81.
(ii) If the six-month forward rate is $ 1.80, the expected profits of the firm can be
maximised by retaining its pounds receivable.
16.
USD/ ` on 3rd September 49.3800

Swap Point for October 0.1300
49.5100
Add: Exchange Margin 0.0500
49.5600
USD/ SGD on 3rd September 1.7058
Swap Point for 2 nd month Forward 0.0096
1.7154
Cross Rate for SGD/ ` of 30th October

USD/ ` selling rate = ` 49.5600
SGD/ ` buying rate = SGD 1.7154
SGD/ ` cross rate = ` 49.5600 / 1.7154 = ` 28.8912
17. Spot rate of ` 1 against yen = 108 lakhs yen/` 30 lakhs = 3.6 yen
3 months forward rate of Re. 1 against yen = 3.3 yen
Anticipated decline in Exchange rate = 10%.
Expected spot rate after 3 months = 3.6 yen – 10% of 3.6 = 3.6 yen – 0.36 yen = 3.24 yen
per rupee
` (in lakhs)
Present cost of 108 lakhs yen 30.00
Cost after 3 months: 108 lakhs yen/ 3.24 yen 33.33
Expected exchange loss 3.33
If the expected exchange rate risk is hedged by a Forward contract:
Present cost 30.00
Cost after 3 months if forward contract is taken 108 lakhs yen/ 3.3 yen 32.73
Expected loss 2.73
Suggestion: If the exchange rate risk is not covered with forward contract, the expected
exchange loss is ` 3.33 lakhs. This could be reduced to ` 2.73 lakhs if it is covered with
Forward contract. Hence, taking forward contract is suggested.
18. Firstly, the interest is calculated at 3% p.a. for 6 months. That is:
USD 20,00,000 × 3/100 × 6/12 = USD 30,000
From the forward points quoted, it is seen that the second figure is less than the first, this
means that the currency is quoted at a discount.
(i) The value of the total commitment in Indian rupees is calculated as below:
Principal Amount of loan USD 20,00,000

Add: Interest USD 30,000
Amount due USD 20,30,000
Spot rate ` 48.5275
Forward Points (6 months) (–) 0.0700
Forward Rate ` 48.4575
Value of Commitment ` 9,83,68,725
(ii) It is seen from the forward rates that the market expectation is that the dollar will
depreciate. If the firm's own expectation is that the dollar will depreciate more than
what the bank has quoted, it may be worthwhile not to cover forward and keep the
exposure open.
If the firm has no specific view regarding future dollar price movements, it would be better to
cover the exposure. This would freeze the total commitment and insulate the firm from
undue market fluctuations. In other words, it will be advisable to cut the losses at this point
of time.
Given the interest rate differentials and inflation rates between India and USA, it would be
unwise to expect continuous depreciation of the dollar. The US Dollar is a stronger currency
than the Indian Rupee based on past trends and it would be advisable to cover the
exposure.
19. (i) Rate of discount quoted by the bank
(45.20 - 45.60) × 365 × 100
= = 5.33%
45.60 × 60
(ii) Probable loss of operating profit:
(45.20 – 45.50)  1,00,000 = ` 30,000
20. Buy £ 62500 × 1.2806 = $ 80037.50

Sell £ 62500 × 1.2816 = $ 80100.00
Profit $ 62.50
Alternatively, if the market comes back together before December 15, the dealer could
unwind his position (by simultaneously buying £ 62,500 forward and selling a futures
contract. Both for delivery on December 15) and earn the same profit of $ 62.5.
21. If importer pays now, he will have to buy US$ in Spot Market by availing overdraft facility.
Accordingly, the outflow under this option will be
`
Amount required to purchase $130000[$130000X`48.36] 6286800
Add: Overdraft Interest for 3 months @15% p.a. 235755
6522555
If importer makes payment after 3 months then, he will have to pay interest for 3 months @
5% p.a. for 3 month along with the sum of import bill. Accordingly, he will have to buy $ in
forward market. The outflow under this option will be as follows:
$
Amount of Bill 130000
Add: Interest for 3 months @5% p.a. 1625
131625
Amount to be paid in Indian Rupee after 3 month under the forward purchase contract
` 6427249 (US$ 131625 X ` 48.83)
Since outflow of cash is least in (ii) option, it should be opted for.
22. (i) Pay the supplier in 60 days
If the payment is made to supplier in 60 days the applicable ` 63.15

forward rate for 1 USD
Payment Due USD 1 crore
Outflow in Rupees (USD 1 crore × ` 63.15) ` 63.15 crore
Add: Interest on loan for 30 days@9.5% p.a. ` 0.50 crore
Total Outflow in ` ` 63.65 crore
(ii) Availing supplier’s offer of 90 days credit
Amount Payable USD 1.00000 crore

Add: Interest on credit period for 30 days@7.75% p.a. USD 0.00646 crore
Total Outflow in USD USD 1.00646 crore
Applicable forward rate for 1 USD ` 63.45
Total Outflow in ` (USD 1.00646 crore ×` 63.45) ` 63.86 crore
Alternative 1 is better as it entails lower cash outflow.
23.
(`)
Present Exchange Rate `65 = 1 US$
If company purchases US$ 60,000 forward premium is
60000 × 64 × 2% 76,800
Interest on `76,800 for 6 months at 12% 4,608
Total hedging cost 81,408
If exchange rate is `68
Then gain (`68 – `64) for US$ 60,000 2,40,000
Less: Hedging cost 81,408
Net gain 1,58,592
If US$ = `62
Then loss (`64 – `62) for US$ 60,000 1,20,000
Add: Hedging Cost 81,408
Total Loss 2,01,408
If US$ = `70
Then Gain (`70 – `64) for US$ 60,000 3,60,000
Less: Hedging Cost 81,408
Total Gain 2,78,592
If US$ = `65
Then Gain (` 65 – ` 64) for US$ 60,000 60,000
Less: Hedging Cost 81,408
Net Loss 21,408
24. If foreign exchange risk is hedged
Total
(` )
Sum due Yen 78,00,000 US$1,02,300 Euro 95,920
Unit input price Yen 650 US$10.23 Euro 11.99
Unit sold 12000 10000 8000
Variable cost per unit `225/- `395/- `510/-
Variable cost `27,00,000 ` 39,50,000 ` 40,80,000 ` 1,07,30,000
Three months forward rate 2.427 0.0216 0.0178
for selling
Rupee value of receipts `32,13,844 ` 47,36,111 ` 53,88,764 ` 1,33,38,719
Contribution `5,13,844 ` 7,86,111 ` 13,08,764 ` 26,08,719
Average contribution to sale 19.56%
ratio
If risk is not hedged
Rupee value of receipt `31,72,021 ` 47,44,898 ` 53,58,659 ` 1,32,75,578
Total contribution ` 25,45,578
Average contribution to sale 19.17%
ratio
AKC Ltd. Is advised to hedge its foreign currency exchange risk.

25. Receipts using a forward contract = $10,000,000/0.016129 = ` 620,001,240
Receipts using currency futures
The number of contracts needed is ($10,000,000/0.016118)/24,816,975 = 25
Initial margin payable is 25 contracts x ` 22,500 = ` 5,62,500
On April 1,2015Close at 0.016134
Receipts = US$10,000,000/0.016136 = ` 619,732,276
Variation Margin =
[(0.016134 – 0.016118) x 25 x 24,816,975/-]/0.016136
OR (0.000016x 25 x 24,816,975)/.016136 = 9926.79/0.016136 = ` 615,195
Less: Interest Cost – ` 5,62,500x 0.07 x 3/12 = ` 9,844
Net Receipts ` 620,337,627
Receipts under different methods of hedging

Forward contract ` 620,001,240
Futures ` 620,337,627
No hedge (US$ 10,000,000/0.016136) ` 619,732,276
The most advantageous option would have been to hedge with futures.
26.
Spot Rate = `40,00,000 /US$83,312 = 48.0123

Forward Premium on US$ = [(48.8190 – 48.0123)/48.0123] x 12/6 x 100
= 3.36%
Interest rate differential = 12% - 8%
= 4%
Since the negative Interest rate differential is greater than forward premium there is a
possibility of arbitrage inflow into India.
The advantage of this situation can be taken in the following manner:
1. Borrow US$ 83,312 for 6 months
Amount to be repaid after 6 months
= US $ 83,312 (1+0.08 x 6/12) = US$86,644.48
2. Convert US$ 83,312 into Rupee and get the principal i.e. `40,00,000
Interest on Investments for 6 months – `40,00,000/- x 0.06 = `2,40,000/-
Total amount at the end of 6 months = `(40,00,000 + 2,40,000) = `42,40,000/-
Converting the same at the forward rate
= `42,40,000/ `48.8190= US$ 86,851.43
Hence the gain is US $ (86,851.43 – 86,644.48) = US$ 206.95 OR
`10,103 i.e., ($206.95 x `48.8190)
27. In this case, DM is at a premium against the Can$.

Premium = [(0.67 – 0.665) /0.665] x (12/3) x 100 = 3.01 per cent
Interest rate differential = 9% - 7% = 2 per cent.
Since the interest rate differential is smaller than the premium, it will be profitable to place
money in Deutschmarks the currency whose 3-months interest is lower.
The following operations are carried out:
(i) Borrow Can$ 1000 at 9 per cent for 3- months;
(ii) Change this sum into DM at the spot rate to obtain DM

= (1000/0.665) = 1503.76
(iii) Place DM 1503.76 in the money market for 3 months to obtain a sum of DM
Principal: 1503.76
Add: Interest @ 7% for 3 months = 26.32
Total 1530.08
(iv) Sell DM at 3-months forward to obtain Can$= (1530.08x0.67) = 1025.15
(v) Refund the debt taken in Can$ with the interest due on it, i.e.,
Can$
Principal 1000.00
Add: Interest @9% for 3 months 22.50
Total 1022.50
Net arbitrage gain = 1025.15 – 1022.50 = Can$ 2.65
28. The only thing lefts Rohit and Bros to cover the risk in the money market. The following
steps are required to be taken:
(i) Borrow pound sterling for 3- months. The borrowing has to be such that at the end of
three months, the amount becomes £ 500,000. Say, the amount borrowed is £ x.
Therefore
 3
x 1 + 0.05   = 500,000 or x = £493,827
 12 
(ii) Convert the borrowed sum into rupees at the spot rate. This gives: £493,827 × ` 56
= ` 27,654,312
(iii) The sum thus obtained is placed in the money market at 12 per cent to obtain at the
end of 3- months:
 3
S = ` 27,654,312 × 1 + 0.12   = ` 28,483,941
 12 
(iv) The sum of £500,000 received from the client at the end of 3- months is used to
refund the loan taken earlier.
From the calculations. It is clear that the money market operation has resulted into a
net gain of ` 483,941 (` 28,483,941 – ` 500,000 × 56).
If pound sterling has depreciated in the meantime. The gain would be even bigger.
29. Identify: Foreign currency is an asset. Amount $ 3,50,000.

Create: $ Liability.
Borrow: In $. The borrowing rate is 9% per annum or 2.25% per quarter.
Amount to be borrowed: 3,50,000 / 1.0225 = $ 3,42,298.29
Convert: Sell $ and buy £. The relevant rate is the Ask rate, namely, 1.5905 per £,
(Note: This is an indirect quote). Amount of £s received on conversion is 2,15,214.27
(3,42,298.29/1.5905).
Invest: £ 2,15,214.27 will be invested at 5% for 3 months and get £ 2,17,904.45
Settle: The liability of $3,42,298.29 at interest of 2.25 per cent quarter matures to
$3,50,000 receivable from customer.
Using forward rate, amount receivable is = 3,50,000 / 1.6140 = £2,16,852.54
Amount received through money market hedge = £2,17,904.45
Gain = 2,17,904.45 – 2,16,852.54 = £1,051.91
So, money market hedge is beneficial for the exporter
30.
End of Year ` `/USD
1 (1+ 0.08)
`46.00 x 47.77
(1+ 0.04)
2 (1+ 0.08)
`47.77 x 49.61
(1+ 0.04)
3 (1+ 0.08)
`49.61 x 51.52
(1+ 0.04)
4 (1+ 0.08)
`51.52 x 53.50
(1+ 0.04)
31. As per interest rate parity
1 + in A 
S1 = S 0  
 1 + in B 
 1 + (0.075)  3 
S1 = £0.7570  12 
 1 + (0.035)  3 
 12 
 1.01875 
= £0.7570  
 1.00875 
= £0.7570 × 1.0099 = £0.7645
= UK £0.7645 / US$
32. (i) The contract is to be cancelled on 30-10-2010 at the spot buying rate of US$ 1
= ` 41.5000
Less: Margin Money 0.075% =` 0.0311
= ` 41.4689 or ` 41.47
US$ 20,000 @ ` 41.47 = ` 8,29,400
US$ 20,000 @ ` 42.32 = ` 8,46,400
The difference in favour of the Bank/Cost to the importer ` 17,000
(ii) The Rate of New Forward Contract
Spot Selling Rate US$ 1 = ` 41.5200
Add: Premium @ 0.93% = ` 0.3861
= ` 41.9061
Add: Margin Money 0.20% = ` 0.0838
= ` 41.9899 or ` 41.99
33. (i) Forward Cover
1
3-month Forward Rate = = ` 0.5070/JY
1.9726
Accordingly, INR required for JY 5,00,000 (5,00,000 X ` 0.5070) ` 2,53,500
(ii) Option Cover
To purchase JY 5,00,000, XYZ shall enter into a Put Option @ JY 2.125/INR
 JY 5,00,000  ` 2,35,294
Accordingly, outflow in INR  
 2.125 
 INR 2,35,294  0.098  ` 11,815

Premium  
 1.9516 
` 2,47,109
Since outflow of cash is least in case of Option same should be opted for. Further if
price of INR goes above JY 2.125/INR the outflow shall further be reduced.
34. The company can hedge position by selling future contracts as it will receive amount from
outside.
$4,00,000
Number of Contracts = = 400 contracts
$1,000
Gain by trading in futures = (` 45 – ` 44.50) 4,00,000= ` 2,00,000

Net Inflow after after 3 months = ` 44.50 x ` 4,00,000+ 2,00,000 = ` 1,80,00,000
` 1,80,00,000
Effective Price realization = = ` 45 Per US$
$4,00,000
35. Option - I
$20 x 5000 = $ 1,00,000
Repayment in 3 months time = $1,00,000 x (1 + 0.10/4) = $ 1,02,500
3-months outright forward rate = ` 59.90/ ` 60.30
Repayment obligation in ` ($1,02,500 X ` 60.30) = ` 61,80,750
Option -II
Overdraft ($1,00,000 x ` 60.55) ` 60,55,000
Interest on Overdraft (` 60,55,000 x 0.14/4) ` 2,11,925
` 62,66,925
Option I should be preferred as it has lower outflow.
36. Forward Market Cover
Hedge the risk by buying Can$ in 1 and 3 months time will be:
July - 1010000 X 0.9301 = US $ 939401
Sept. - 705000 X 0.9356 = US $ 659598
Option Contracts
July Payment = 1010000/ 50,000 = 20.20
September Payment = 705000/ 50,000 = 14.10
Company would like to take out 20 contracts for July and 14 contracts for September
respectively. Therefore costs, if the options were exercised, will be:
July Sept.
Can $ US $ Can $ US $
Covered by Contracts 1000000 940000 700000 665000
Balance bought at spot rate 10000 9301 5000 4678
Option Costs:
Can $ 50000 x 20 x 0.0102 10200 ---
Can $ 50000 x 14 x 0.0164 --- 11480
Total cost in US $ of using Option Contract 959501 681158
Decision: As the firm is stated as risk averse and the money due to be paid is certai n, a
fixed forward contract, being the cheapest alternative in the both the cases, would be
recommended.
37. (i) Receipt under three proposals
(a) Proposal of Mr. Peter
€ 2.8 million
Invoicing in £ will produce = = £ 2.340 million
1.1965
(b) Proposal of Mr. Wilson
Forward Rate = €1.1970-0.0055 = 1.1915
€ 2.8 million
Using Forward Market hedge Sterling receipt would be = £
1.1915
2.35 million
(c) Proposal of Ms. Karen
The equivalent sterling of the order placed based on future price (€1.1943)
€ 2.8 million
= = £ 2,344,470 (rounded off)
1.1943
£2,344,470
Number of Contracts = = 37 Contracts (to the nearest whole number)
62,500
Thus, € amount hedged by future contract will be = 37  £62,500 = £23,12,500

Buy Future at €1.1943
Sell Future at €1.1873
€0.0070
Total loss on Future Contracts = 37  £62,500  €0.0070 =€16,188

After 6 months
Amount Received €28,00,000
Less: Loss on Future Contracts € 16,188
€ 27,83,812
Sterling Receipts
€ 27,83,812
On sale of € at spot = = £ 2.3446 million
1.1873
(ii) Proposal of option (b) is preferable because the option (a) & (c) produces least
receipts. Further, in case of proposal (a) there must be a doubt as to whether this
would be acceptable to German firm as it is described as a competitive market and
Zaz is moving into it first time.
38. £ Exposure
Since Columbus has a £ receipt (£ 138,000) and payment of (£ 480,000) maturing at the
same time i.e. 3 months, it can match them against each other leaving a net liability of £
342,000 to be hedged.
(i) Forward market hedge
Buy 3 months' forward contract accordingly, amount payable after 3 months will be
£ 342,000 / 0.9520 = US$ 359,244
(ii) Money market hedge
To pay £ after 3 months' Columbus shall requires to borrow in US$ and translate to £
and then deposit in £.
For payment of £ 342,000 in 3 months (@2.5% interest) amount required to be
deposited now (£ 342,000 ÷ 1.025) = £ 333,658
With spot rate of 0.9830 the US$ loan needed will be = US$ 339,429
Loan repayable after 3 months (@3.25% interest) will be = US$ 350,460
In this case the money market hedge is a cheaper option.
€ Receipt
Amount to be hedged = € 590,000
(i) Forward market hedge

Sell 4 months' forward contract accordingly, amount
receivable after 4 months will be (€ 590,000 x1.9510) = US$ 1,151,090
(ii) Money market hedge
For money market hedge Columbus shall borrow in
€ and then translate to US$ and deposit in US$
For receipt of € 590,000 in 4 months (@ 5.33% interest)

amount required to be borrowed now (€590,000 ÷ 1.0533) = € 560,144
With spot rate of 1.8890 the US$ deposit will be = US$ 1,058,113
Deposit amount will increase over 3 months
(@3.83% interest) will be = US$ 1,098,639
In this case, more will be received in US$ under the forward hedge.
39. (a) Forward contract: Dollar needed in 180 days = £3,00,000 x $ 1.96 = $5,88,000/ -
(b) Money market hedge: Borrow $, convert to £, invest £, repay $ loan in 180 days
Amount in £ to be invested = 3,00,000/1.045 = £ 2,87,081
Amount of $ needed to convert into £ = 2,87,081 x 2 = $ 5,74,162
Interest and principal on $ loan after 180 days = $5,74,162 x 1.055 = $ 6,05,741
(c) Call option:
Expected Prem. Exercise Total price Total price Prob. Pi pixi

Spot rate /unit Option per unit for
in 180 £3,00,000xi
days
1.91 0.04 No 1.95 5,85,000 0.25 1,46,250
1.95 0.04 No 1.99 5,97,000 0.60 3,58,200
2.05 0.04 Yes 2.01* 6,03,000 0.15 90,450
5,94,900
Add: Interest on Premium @ 5.5% (12,000 x 5.5%) 660
5,95,560
* ($1.97 + $0.04)
(d) No hedge option:
Expected Future Dollar needed Prob. Pi Pi xi

spot rate Xi
1.91 5,73,000 0.25 1,43,250
1.95 5,85,000 0.60 3,51,000
2.05 6,15,000 0.15 92,250
5,86,500
The probability distribution of outcomes for no hedge strategy appears to be most

preferable because least number of $ are needed under this option to arrange
£3,00,000.
40. In the given case, the exchange rates are indirect. These can be converted into direct rates
as follows:
Spot rate
1 1
GBP = to
USD1.5617 USD1.5673
USD = GBP 0.64033 - GBP 0.63804

6 months’ forward rate
1 1
GBP = to
USD1.5455 USD1.5609
USD = GBP 0.64704 - GBP 0.64066

Payoff in 3 alternatives
i. Forward Cover
Amount payable USD 3,64,897
Forward rate GBP 0.64704
Payable in GBP GBP 2,36,103
ii. Money market Cover

1 USD 3,56,867
PV @ 4.5% for 6 months i.e. = 0.9779951
1.0225
Spot rate purchase GBP 0.64033
Borrow GBP 3,56,867 x 0.64033 GBP 2,28,512

Interest for 6 months @ 7 % 7,998
-
Payable after 6 months GBP 2,36,510
iii. Currency options

Unit in Options contract GBP 12,500
Value in USD at strike rate of 1.70 (GBP 12,500 x 1.70) USD 21,250
Number of contracts USD 3,64,897/ USD 21,250 17.17
Exposure covered USD 21,250 x 17 USD 3,61,250
Exposure to be covered by Forward (USD 3,64,897 – USD USD 3,647
3,61,250)
Options premium 17 x GBP 12,500 x 0.096 USD 20,400
Premium in GBP (USD 20,400 x 0.64033) GBP 13,063
Total payment in currency option
Payment under option (17 x 12,500) GBP 2,12,500
Premium payable GBP 13,063
Payment for forward cover (USD 3,647 x 0.64704) GBP 2,360
GBP 2,27,923
Thus total payment in:
(i) Forward Cover 2,36,103 GBP

(ii) Money Market 2,36,510 GBP
(iii) Currency Option 2,27,923 GBP
The company should take currency option for hedging the risk.
Note: Even interest on Option Premium can also be considered in the above solution.
41. (i) Receipt under three proposals
(a) Invoicing in Sterling
€ 4 million
Invoicing in £ will produce = = £3398471
1.1770
(b) Use of Forward Contract
Forward Rate = €1.1770+0.0055 = 1.1825
€ 4 million
Using Forward Market hedge Sterling receipt would be
1.1825
= £ 3382664
(c) Use of Future Contract
The equivalent sterling of the order placed based on future price (€1.1760)
€ 4.00 million
= = £ 3401360
1.1760
£3401360
Number of Contracts = = 54 Contracts (to the nearest whole
62,500
number)
Thus, € amount hedged by future contract will be = 54  £62,500
= £3375000
Buy Future at €1.1760
Sell Future at €1.1785
€0.0025
Total profit on Future Contracts = 54  £62,500  €0.0025 = €8438
After 6 months
Amount Received € 4000000
Add: Profit on Future Contracts € 8438
€ 4008438
Sterling Receipts
€ 4008438
On sale of € at spot = = €3401305
1.1785
(ii) Proposal of option (c) is preferable because the option (a) & (b) produces least
receipts.
42. Option I (To finance the purchases by availing loan at 18% per annum):
Cost of equipment ` in lakhs
3400 lakh yen at `100 = 340 yen 1,000.00
Add: Interest at 4.5% I Quarter 45.00
Add: Interest at 4.5% II Quarter (on `1045 lakhs) 47.03
Total outflow in Rupees 1,092.03
Alternatively, interest may also be calculated on compounded basis, i.e.,
`1000 × [1.045]² `1092.03
Option II (To accept the offer from foreign branch):

Cost of letter of credit
At 1 % on 3400 lakhs yen at `100 = 340 yen ` 10.00 lakhs
Add: Interest for 2 Quarters ` 0.90 lakhs
(A) ` 10.90 lakhs
Payment at the end of 180 days:
Cost 3400.00 lakhs yen
Interest at 2% p.a. [3400 × 2/100 × 180/365] 33.53 lakhs yen
3433.53 lakhs yen
Conversion at `100 = 345 yen [3433.53 / 345 ×100] (B) ` 995.23 lakhs
Total Cost: (A) + (B) ` 1006.13 lakhs
Advise: Option 2 is cheaper by (1092.03 – 1006.13) lakh or ` 85.90 lakh. Hence, the offer
may be accepted.
43. (A) To cover payable and receivable in forward Market
Amount payable after 3 months $7,00,000
Thus Payable Amount (`) (A) ` 3,39,15,000
Amount receivable after 2 months $ 4,50,000
Thus Receivable Amount (`) (B) ` 2,20,05,000
Interest @ 12% p.a. for 1 month (C) ` 2,20,050
Net Amount Payable in (`) (A) – (B) – (C) ` 1,16,89,950
(B) Assuming that since the forward contract for receivable was already booked it shall
be cancelled if we lag the receivables. Accordingly, any profit/ loss on cancellation of
contract shall also be calculated and shall be adjusted as follows:
Amount Payable ($) $7,00,000
Amount receivable after 3 months $ 4,50,000
Net Amount payable $2,50,000
Applicable Rate ` 48.45
Amount payable in (`) (A) ` 1,21,12,500
Profit on cancellation of Forward cost ` 2,70,000
(48.90 – 48.30) × 4,50,000 (B)
Thus, net amount payable in (`) (A) + (B) ` 1,18,42,500
Since net payable amount is least in case of first option, hence the company should cover
payable and receivables in forward market.
Note: In the question it has not been clearly mentioned that whether quotes given for 2 and
3 months (in points terms) are premium points or direct quotes. Although above solution is
based on the assumption that these are direct quotes, but students can also consider them
as premium points and solve the question accordingly.
44. The contract would be cancelled at the one-month forward sale rate of ` 27.52.
`
Francs bought from customer under original forward contract at: 27.25
It is sold to him on cancellation at: 27.52
Net amount payable by customer per Franc 0.27
At ` 0.27 per Franc, exchange difference for CHF 10,000 is ` 2,700.
Loss to the Customer:
Exchange difference (Loss) ` 2,700
Note: The exchange commission and other service charges are ignored.
45. First the contract will be cancelled at TT Selling Rate
USD/ Rupee Spot Selling Rate ` 49.4455
Add: Premium for April ` 0.4200
` 49.8655
Add: Exchange Margin @ 0.10% ` 0.04987
` 49.91537 Or 49.9154
USD/ Sw. Fcs One Month Buying Rate Sw. Fcs. 1.5150
Sw. Fcs. Spot Selling Rate (`49.91537/1.5150) ` 32.9474
Rounded Off ` 32.9475
Bank buys Sw. Fcs. Under original contract ` 32.4000
Bank Sells under Cancellation ` 32.9475
Difference payable by customer ` 00.5475
Exchange difference of Sw. Fcs. 1,00,000 payable by customer ` 54,750
(Sw. Fcs. 1,00,000 x ` 0.5475)
46. The amount of EURO bought by selling US$

US$ 10,00,000 * EURO 1.4400 = EURO 14,40,000
The amount of EURO sold for buying USD 10,00,000 * 1.4450 = EURO 14,45,000
Net Loss in the Transaction = EURO 5,000
To acquire EURO 5,000 from the market @
(a) USD 1 = EURO 1.4400 &
(b) USD1 = INR 31.4500
Cross Currency buying rate of EUR/INR is ` 31.4500 / 1.440 i.e. ` 21.8403
Loss in the Transaction ` 21.8403 * 5000 = ` 1,09,201.50
Alternatively, if delivery to be affected then computation of loss shall be as follows:
EURO to be surrendered to acquire $ 10,00,000 = EURO 14,45,000
EURO to be received after selling $ 10,00,000 = EURO 14,40,000
Loss = EURO 5,000
To acquire EURO 5,000 from market @
US $ 1 = EURO 1.4400
US $ 1 = INR 31.45
31.45
Cross Currency = = ` 21.8403
1.440
Loss in Transaction (21.8403 x EURO 5,000) = ` 1,09,201.50
47. (i) To Buy 1 Million GBP Spot against CHF
1. First to Buy USD against CHF at the cheaper rate i.e. from Bank A.
1 USD = CHF 1.4655
2. Then to Buy GBP against USD at a cheaper rate i.e. from Bank B 1 GBP
= USD 1.7650
By applying chain rule Buying rate would be
1 GBP = 1.7650 * 1.4655 CHF
1 GBP = CHF 2.5866
Amount payable CHF 2.5866 Million or CHF 25,86,600
(ii) Spot rate Bid rate GBP 1 = CHF 1.4650 * 1.7645 = CHF 2.5850
Offer rate GBP 1 = CHF 1.4655 * 1.7660 = CHF 2.5881
GBP / USD 3 months swap points are at discount
Outright 3 Months forward rate GBP 1 = USD 1.7620 / 1.7640
USD / CHF 3 months swap points are at premium

Outright 3 Months forward rate USD 1 = CHF 1.4655 / 1.4665
Hence
Outright 3 Months forward rate GBP 1 = CHF 2.5822 / 2.5869
Spot rate GBP 1 = CHF 2.5850 / 2.5881
Therefore 3-month swap points are at discount of 28/12.
48. (i) Profit at current exchange rates
2400 [€ 500 × ` 51.50 – (S$ 800 × ` 27.25 + ` 1,000 + ` 1,500)]
2400 [` 25,750 - ` 24,300] = ` 34,80,000
Profit after change in exchange rates
2400[€500× ` 52 – (S$ 800 × ` 27.75 + ` 1000 + ` 1500)]
2400[` 26,000 - ` 24,700] = ` 31,20,000
LOSS DUE TO TRANSACTION EXPOSURE
` 34,80,000 – ` 31,20,000 = ` 3,60,000
(ii) Profit based on new exchange rates
2400[` 25,000 - (800 × ` 27.15 + ` 1,000 + ` 1,500)]
2400[` 25,000 - ` 24,220] = ` 18,72,000
Profit after change in exchange rates at the end of six months
2400 [` 25,000 - (800 × ` 27.75 + ` 1,000 + ` 1,500)]
2400 [`. 25,000 - ` 24,700] = ` 7,20,000
Decline in profit due to transaction exposure
` 18,72,000 - ` 7,20,000 = ` 11,52,000
` 25,000
Current price of each unit in € = = € 485.44
` 51.50
` 25,000
Price after change in Exch. Rate = = € 483.09
` 51.75
Change in Price due to change in Exch. Rate
€ 485.44 - € 483.09 = € 2.35 or (-) 0.48%
Price elasticity of demand = 1.5
Increase in demand due to fall in price 0.48 × 1.5 = 0.72%
Size of increased order = 2400 ×1.0072 = 2417 units
Profit = 2417 [ ` 25,000 – (800 × ` 27.75 + ` 1,000 + ` 1,500)]

= 2417 [ ` 25,000 - ` 24,700] = ` 7,25,100
Therefore, decrease in profit due to operating exposure ` 18,72,000 – ` 7,25,100
= ` 11,46,900
Alternatively, if it is assumed that Fixed Cost shall not be changed with change in
units then answer will be as follows:
Fixed Cost = 2400[` 1,000] = ` 24,00,000
Profit = 2417 [ ` 25,000 – (800 × ` 27.75 + ` 1,500)] – ` 24,00,000
= 2417 ( ` 1,300) – ` 24,00,000 = ` 7,42,100
Therefore, decrease in profit due to operating exposure ` 18,72,000 – ` 7,42,100
= ` 11,29,900
49. (i) If investment is made at London
Convert US$ 5,00,000 at Spot Rate (5,00,000/1.5390) = £ 3,24,886
Add: £ Interest for 3 months on £ 324,886 @ 5% =£ 4,061
= £ 3,28,947
Less: Amount Invested $ 5,00,000
Interest accrued thereon $ 5,000
= $ 5,05,000
Equivalent amount of £ required to pay the
above sum ($ 5,05,000/1.5430*) = £ 3,27,285
Arbitrage Profit =£ 1,662
(ii) If investment is made at New York
Gain $ 5,00,000 (8% - 4%) x 3/12 = $ 5,000
Equivalent amount in £ 3 months ($ 5,000/ 1.5475) £ 3,231
(iii) If investment is made at Frankfurt
Convert US$ 500,000 at Spot Rate (Cross Rate) 1.8260/1.5390= € 1.1865
Euro equivalent US$ 500,000 = € 5,93,250
Add: Interest for 3 months @ 3% =€ 4,449
= € 5,97,699
3 month Forward Rate of selling € (1/1.8150) = £ 0.5510

Sell € in Forward Market € 5,97,699 x £ 0.5510 = £ 3,29,332
Less: Amounted invested and interest thereon = £ 3,27,285
Arbitrage Profit =£ 2,047
Since out of three options the maximum profit is in case investment is made in New York.
Hence it should be opted.
* Due to conservative outlook.
50. (a) The following swap arrangement can be entered by Drilldip.
(i) Swap a US$ loan today at an agreed rate with any party to obtain Indian
Rupees (`) to make initial investment.
(ii) After one year swap back the Indian Rupees with US$ at the agreed rate.
In such case the company is exposed only on the profit earned from the
project.
(b) With the swap
Year 0 Year 1
(Million US$) (Million US$)
Buy ` 500 crore at spot rate of 1US$ = ` 50 (100.00) ----
Swap ` 500 crore back at agreed rate of ` 50 ---- 100.00
Sell ` 240 crore at 1US$ = ` 54 ---- 44.44
Interest on US$ loan @8% for one year ---- (8.00)
(100.00) 136.44
Net result is a net receipt of US$ 36.44 million.

Without the swap
Year 0 Year 1(Million

(Million US$) US$)
Buy ` 500 crore at spot rate of 1US$ = ` 50 (100.00) ----
Sell ` 740 crore at 1US$ = ` 54 ---- 137.04
Interest on US$ loan @8% for one year ---- (8.00)
(100.00) 129.04
Net result is a net receipt of US$ 29.04 million.
Decision: Since the net receipt is higher in swap option the company should opt for
the same.
51. Exchange Position:
Particulars Purchase Sw. Fcs. Sale Sw. Fcs.
Opening Balance Overbought 50,000
Bill on Zurich 80,000
Forward Sales – TT 60,000
Cancellation of Forward Contract 30,000
TT Sales 75,000
Draft on Zurich cancelled 30,000 —
1,60,000 1,65,000
Closing Balance Oversold 5,000 —
1,65,000 1,65,000
Cash Position (Nostro A/c)

Credit Debit
Opening balance credit 1,00,000 —
TT sales — 75,000
1,00,000 75,000
Closing balance (credit) — 25,000
1,00,000 1,00,000
The Bank has to buy spot TT Sw. Fcs. 5,000 to increase the balance in Nostro account to
Sw. Fcs. 30,000.
This would bring down the oversold position on Sw. Fcs. as Nil.
Since the bank requires an overbought position of Sw. Fcs. 10,000, it has to buy forward Sw.
Fcs. 10,000.
10
INTERNATIONAL FINANCIAL
MANAGEMENT
LEARNING OUTCOMES
❑ International Capital Budgeting

❑ International Sources of Finance
❑ International Working Capital Management
(a) International Working Capital Management
(b) Multinational Cash Management
(c) Multinational Inventory Management
(b) Multinational Receivable Management
1. INTERNATIONAL CAPITAL BUDGETING

1.1 Complexities Involved
Multinational Capital Budgeting has to take into consideration the different factors and variables
which affect a foreign project and are complex in nature than domestic projects. The factors crucial
in such a situation are:
(a) Cash flows from foreign projects have to be converted into the currency of the parent
organization.
(b) Parent cash flows are quite different from project cash flows
(c) Profits remitted to the parent firm are subject to tax in the home country as well as the host
country
(d) Effect of foreign exchange risk on the parent firm’s cash flow
(e) Changes in rates of inflation causing a shift in the competitive environment and thereby
affecting cash flows over a specific time period
(f) Restrictions imposed on cash flow distribution generated from foreign projects by the hos t
country
(g) Initial investment in the host country to benefit from the release of blocked funds
(h) Political risk in the form of changed political events reduce the possibility of expected cash
flows
(i) Concessions/benefits provided by the host country ensures the upsurge in the profitability
position of the foreign project
(j) Estimation of the terminal value in multinational capital budgeting is difficult since the
buyers in the parent company have divergent views on acquisition of the project.
1.2 Problems Affecting Foreign Investment Analysis
The various types of problems faced in International Capital Budgeting analysis are as follows:
(1) Multinational companies investing elsewhere are subjected to foreign exchange risk in the
sense that currency appreciates/ depreciates over a span of time. To include foreign exchange risk
in the cash flow estimates of any project, it is necessary to forecast the inflation rate in the host
country during the lifetime of the project. Adjustments for inflation are made in the cash flows
depicted in local currency. The cash flows are converted in parent country’s currency at the spot
exchange rate multiplied by the expected depreciation rate obtained from purchasing power parity.
(2) Due to restrictions imposed on transfer of profits, depreciation charges and technical
specifications differences exist between project cash flows and cash flows obtained by the parent
organization. Such restriction can be diluted by the application of techniques viz internal transfer
prices, overhead payments. Adjustment for blocked funds depends on its opportunity cost, a vital
issue in capital budgeting process.
(3) In Multinational Capital Budgeting, after tax cash flows need to be considered for project
evaluation. The presence of two tax regimes along with other factors such as remittances to the
parent firm in the form of royalties, dividends, management fees etc, tax provisions with held in the
host country, presence of tax treaties, tax discrimination pursued by the host country between
transfer of realized profits vis-à-vis local re-investment of such profits cause serious impediments
to multinational capital budgeting process. MNCs are in a position to reduce overall tax burden
through the system of transfer pricing.
INTERNATIONAL FINANCIAL MANAGEMENT 710.3
For computation of actual after tax cash flows accruing to the parent firm, higher of home/ host
country tax rate is used. If the project becomes feasible then it is acceptable under a more
favourable tax regime. If not feasible, then, other tax saving aspects need to be incorporated in
order to find out whether the project crosses the hurdle rate.
1.3 Project vis-a-vis Parent Cash Flows
There exists a big difference between the project and parent cash flows due to tax rules, exchange
controls. Management and royalty payments are returns to the parent firm. The basis on which a
project shall be evaluated depend on one’s own cash flows, cash flows accruing to the parent firm
or both.
Evaluation of a project on the basis of own cash flows entails that the project shoul d compete
favourably with domestic firms and earn a return higher than the local competitors. If not, the
shareholders and management of the parent company shall invest in the equity/government bonds
of domestic firms. A comparison cannot be made since foreign projects replace imports and are
not competitors with existing local firms. Project evaluation based on local cash flows avoid
currency conversion and eliminates problems associated with fluctuating exchange rate changes.
For evaluation of foreign project from the parent firm’s angle, both operating and financial cash
flows actually remitted to it form the yardstick for the firm’s performance and the basis for
distribution of dividends to the shareholders and repayment of debt/interest to lenders. An
investment has to be evaluated on basis of net after tax operating cash flows generated by the
project. As both types of cash flows (operating and financial) are clubbed together, it is essential to
see that financial cash flows are not mixed up with operating cash flows.
1.4 Discount Rate and Adjusting Cash Flows
An important aspect in multinational capital budgeting is to adjust cash flows or the discount rate
for the additional risk arising from foreign location of the project. Earlier MNCs adjusted the
discount rate upwards for riskier projects as they considered uncertainties in political environment
and foreign exchange fluctuations. The MNCs considered adjusting the discount rate to be popular
as the rate of return of a project should be in conformity with the degree of risk. It is not proper to
combine all risks into a single discount rate. Political risk/uncertainties attached to a project relate
to possible adverse effects which might occur in future but cannot be foreseen at present. So
adjusting discount rates for political risk penalises early cash flows more than distant cash flows.
Also adjusting discount rate to offset exchange risk only when adverse exchange rate movements
are expected is not proper since a MNC can gain from favourable currency movements during the
life of the project on many occasions. Instead of adjusting discount rate while considering risk it is
worthwhile to adjust cash flows. The annual cash flows are discounted at a rate applicable to the
project either at that of the host country or parent country. Probability with certainty equivalent
method along with decision tree analysis are used for economic and financial forecasting. Cash
flows generated by the project and remitted to the parent during each period are adjusted fo r
political risk, exchange rate and other uncertainties by converting them into certainty equivalents.
1.5 Adjusted Present Value (APV)

APV is used in evaluating foreign projects. The APV model is a value additive approach to capital
budgeting process i.e. each cash flow is considered individually and discounted at a rate
consistent with risk involved in the cash flow.
Different components of the project’s cash flow have to be discounted separately.
The APV method uses different discount rates for different segments of the total cash flows
depending on the degree of certainty attached with each cash flow. The financial analyst tests the
basic viability of the foreign project before accounting for all complexities. If the project is feasible
no further evaluation based on accounting for other cash flows is done. If not feasible, an
additional evaluation is done taking into consideration the other complexities.
The APV model is represented as follows.
n n n
Xt Tt St
- I0 +  (1+ k )  (1 + i )  (1+ i )
t =1
* t
+
t =1
t
+
t =1
t
d d
Where I0 → Present Value of Investment Outlay

Xt
→ Present Value of Operating Cash Flow
(1 + k ) * t
Tt
→ Present Value of Interest Tax Shields
(1+ i ) d
t
St
→ Present Value of Interest Subsidies
(1 + id )t
Tt → Tax Saving in year t due to financial mix adopted
S t → Before tax value of interests subsidies (on home currency) in year t due to
project specific financing
id → Before tax cost of dollar dept (home currency)
The initial investment will be net of any ‘Blocked Funds’ that can be made use of by the parent
company for investment in the project. ‘Blocked Funds’ are balances held in foreign countries that
cannot be remitted to the parent due to Exchange Control regulations. These are ‘Direct Blocked
Funds’. Apart from this, it is quite possible that significant costs in the form of local taxes or
withholding taxes arise at the time of remittance of the funds to the parent country. Such ‘Blocked
Funds’ are indirect. If a parent company can release such ‘Blocked Funds’ in one country for the
investment in a overseas project, then such amounts will go to reduce the ‘Cost of Investment
Outlay’.
The last two terms are discounted at the before tax cost of debt to reflect the relative cash flows
due to tax and interest savings.
1.6 Scenarios
Following three illustrations are based on three different scenarios:
1.6.1 A foreign company is investing in India
Illustration 1
Perfect Inc., a U.S. based Pharmaceutical Company has received an offer from Aidscure Ltd., a
company engaged in manufacturing of drugs to cure Dengue, to set up a manufacturing unit in
Baddi (H.P.), India in a joint venture.
As per the Joint Venture agreement, Perfect Inc. will receive 55% share of revenues plus a royalty
@ US $0.01 per bottle. The initial investment will be `200 crores for machinery and factory. The
scrap value of machinery and factory is estimated at the end of five (5) year to be `5 crores. The
machinery is depreciable @ 20% on the value net of salvage value using Straight Line Method. An
initial working capital to the tune of `50 crores shall be required and thereafter `5 crores each
year.
As per GOI directions, it is estimated that the price per bottle will be `7.50 and production will be
24 crores bottles per year. The price in addition to inflation of respective years shall be increased
by `1 each year. The production cost shall be 40% of the revenues.
The applicable tax rate in India is 30% and 35% in US and there is Double Taxation Avoidance
Agreement between India and US. According to the agreement tax credit shall be given in US for
the tax paid in India. In both the countries, taxes shall be paid in the following year in which profit
have arisen/ remittance received.
The Spot rate of $ is `57. The inflation in India is 6% (expected to decrease by 0.50% every year)
and 5% in US.
As per the policy of GOI, only 50% of the share can be remitted in the year in which they are
realised and remaining in the following year.
Though WACC of Perfect Inc. is 13% but due to risky nature of the project it expects a return of 15%.
Determine whether Perfect Inc. should invest in the project or not (from subsidiary point of view).
Solution
Working Notes:
1. Estimated Exchange Rates (Using PPP Theory)
Year 0 1 2 3 4 5 6
Exchange rate * 57 57.54 57.82 57.82 57.54 56.99 56.18
2. Share in sales
Year 1 2 3 4 5
Annual Units in crores 24 24 24 24 24
Price per bottle (`) 7.50 8.50 9.50 10.50 11.50
Price fluctuating Inflation Rate 6.00% 5.50% 5.00% 4.50% 4.00%
Inflated Price (`) 7.95 8.97 9.98 10.97 11.96
Inflated Sales Revenue (` Crore) 190.80 215.28 239.52 263.28 287.04
Sales share @55% 104.94 118.40 131.74 144.80 157.87
3. Royalty Payment
Year 1 2 3 4 5
Annual Units in crores 24 24 24 24 24
Royalty in $ 0.01 0.01 0.01 0.01 0.01
Total Royalty ($ Crore) 0.24 0.24 0.24 0.24 0.24
Exchange Rate 57.54 57.82 57.82 57.54 56.99
Total Royalty (` Crore) 13.81 13.88 13.88 13.81 13.68
4. Tax Liability
(` Crore)
Year 1 2 3 4 5
Sales Share 104.94 118.40 131.74 144.80 157.87
Total Royalty 13.81 13.88 13.88 13.81 13.68
Total Income 118.75 132.28 145.61 158.61 171.55
Less: Expenses
Production Cost (Sales share x 40%) 41.98 47.36 52.69 57.92 63.15
Depreciation (195 x 20%) 39.00 39.00 39.00 39.00 39.00
PBT 37.77 45.92 53.92 61.69 69.40
Tax on Profit @30% 11.33 13.78 16.18 18.51 20.82
Net Profit 26.44 32.14 37.74 43.18 48.58
5. Free Cash Flow

(` Crore)
Year 0 1 2 3 4 5 6
Sales Share 0.00 104.94 118.40 131.74 144.80 157.87 0.00
Total Royalty 0.00 13.81 13.88 13.88 13.81 13.68 0.00
Production Cost 0.00 -41.98 -47.36 -52.69 -57.92 -63.15 0.00
Initial Outlay -200.00 0.00 0.00 0.00 0.00 0.00 0.00
Working Capital -50.00 -5.00 -5.00 -5.00 -5.00 70.00 0.00
Scrap Value 0.00 0.00 0.00 0.00 0.00 5.00 0.00
Tax on Profit 0.00 0.00 -11.33 -13.78 -16.18 -18.51 -20.82
Free Cash Flow -250.00 71.77 68.59 74.15 79.51 164.89 -20.82
6. Remittance of Cash Flows

(` Crore)
Year 0 1 2 3 4 5 6
Free Cash Flow -250.00 71.77 68.59 74.15 79.51 164.89 -20.82
50% of Current Year
Cash Flow 0.00 35.89 34.29 37.07 39.76 82.45 0.00
Previous year
remaining cash flow 0.00 0.00 35.88 34.30 37.08 39.75 82.44
Total Remittance -250.00 35.88 70.17 71.37 76.84 122.20 61.62
NPV of Project under Appraisal

Year 0 1 2 3 4 5 6 7
Total Remittance
(` Crore) -250.00 35.88 70.17 71.37 76.84 122.20 61.62 -
Exchange Rate 57.00 57.54 57.82 57.82 57.54 56.99 56.18 -
Remittance ($ mn) -43.86 6.24 12.14 12.34 13.35 21.44 10.97 -
US Tax @35% ($ mn) 0.00 0.00 2.18 4.25 4.32 4.67 7.50 3.84
Indian Tax ($ mn) 0.00 0.00 1.96 2.38 2.82 3.25 3.71 -
Net Tax ($ mn) 0.00 0.00 0.22 1.87 1.51 1.42 3.79 3.84
Net Cash Flow ($ mn) -43.86 6.24 11.92 10.47 11.84 20.02 7.18 -3.84
PVF @ 15% 1.000 0.870 0.756 0.658 0.572 0.497 0.432 0.376
Present Value ($ mn) -43.86 5.43 9.01 6.89 6.77 9.95 3.10 -1.44
Net Present Value ($ mn) = -4.15
Decision: Since NPV of the project is negative, Perfect inc. should not invest in the project.
* Estimated exchange rates have been calculated by using the following formula:
Expected spot rate = Current Spot Rate x expected difference in inflation rates
(1 + Id )
E(S1) = S0 x
(1 + 1f )
Where
E(S1) is the expected Spot rate in time period 1
S0 is the current spot rate (Direct Quote)
Id is the inflation in the domestic country (home country)
If is the inflation in the foreign country
1.6.2 An Indian Company is investing in foreign country by raising fund in the same
country
Illustration 2
Its Entertainment Ltd., an Indian Amusement Company is happy with the success of its Water Park
in India. The company wants to repeat its success in Nepal also where it is planning to establish a
Grand Water Park with world class amenities. The company is also encouraged by a marketing
research report on which it has just spent ` 20,00,000 lacs.
The estimated cost of construction would be Nepali Rupee (NPR) 450 crores and it would be
completed in one years time. Half of the construction cost will be paid in the beginning and r est at
the end of year. In addition, working capital requirement would be NPR 65 crores from the year
end one. The after tax realizable value of fixed assets after four years of operation is expected to
be NPR 250 crores. Under the Foreign Capital Encouragement Policy of Nepal, company is
allowed to claim 20% depreciation allowance per year on reducing balance basis subject to
maximum capital limit of NPR 200 crore. The company can raise loan for theme park in Nepal
@ 9%.
The water park will have a maximum capacity of 20,000 visitors per day. On an average, it is
expected to achieve 70% capacity for first operational four years. The entry ticket is expected to be
NPR 220 per person. In addition to entry tickets revenue, the company could earn revenue from
sale of food and beverages and fancy gift items. The average sales expected to be NPR 150 per
visitor for food and beverages and NPR 50 per visitor for fancy gift items. The sales margin on
food and beverages and fancy gift items is 20% and 50% respectively. The park would open for
360 days a year.
The annual staffing cost would be NPR 65 crores per annum. The annual insurance cost would be
NPR 5 crores. The other running and maintenance costs are expected to be NPR 25 crores in the
first year of operation which is expected to increase NPR 4 crores every year. The company would
apportion existing overheads to the tune of NPR 5 crores to the park.
All costs and receipts (excluding construction costs, assets realizable value and other running and
maintenance costs) mentioned above are at current prices (i.e. 0 point of time) which are expected
to increase by 5% per year.
The current spot rate is NPR 1.60 per `. The tax rate in India is 30% and in Nepal it is 20%.
The current WACC of the company is 12%. The average market return is 11% and interest rate on
treasury bond is 8%. The company’s current equity beta is 0.45. The company’s funding ratio for
the Water Park would be 55% equity and 45% debt.
Being a tourist Place, the amusement industry in Nepal is competitive and very different from its
Indian counterpart. The company has gathered the relevant information about its nearest
competitor in Nepal. The competitor’s market value of the equity is NPR 1850 crores and the debt
is NPR 510 crores and the equity beta is 1.35.
State whether Its Entertainment Ltd. should undertake Water Park project in Nepal or not.
Solution
Working Notes:
1. Calculation of Cost of Funds/ Discount Rate
Competing Company's Information
Equity Market Value 1850.00
Debt Market Value 510.00
Equity Beta 1.35
Assuming debt to be risk free i.e. beta is zero, the beta of competitor is un-geared as
follows:
E 1850
Asset Beta = Equity Beta x = 1.35 x = 1.106
E + D(1 - t) 1850 + 510(1- 0.20)
Equity beta for Its Entertainment Ltd. in Nepal

Assets beta in Nepal 1.106
Ratio of funding in Nepal
Equity 55.00%
Debt 45.00%
55
1. 1.106 = Equity Beta x
55 + 45(1- 0.30)
Equity Beta = 1.74

Cost of Equity as per CAPM
Market Return 11.00%
Risk free return 8.00%
Cost of Equity = Risk free return + β (Market Return - Risk free return)
= 8.00% + 1.74(11.00% - 8.00%) = 13.22%
WACC = 13.22% x 0.55 + 9%(1- 0.20) x 0.45 = 10.51%
2. Present Value Factors at the discount rate of 10.51%
Year 0 1 2 3 4 5
PVAF 1.000 0.905 0.819 0.741 0.670 0.607
3. Calculation of Capital Allowances
Year 1 2 3 4
Opening Balance (NPR Crore) 200.00 160.00 128.00 102.40
Less: Depreciation (NPR Crore) 40.00 32.00 25.60 20.48
Closing Balance (NPR Crore) 160.00 128.00 102.40 81.92
Calculation of Present of Free Cash Flow
Year 0 1 2 3 4 5
Expected Annual
visitors 5040000 5040000 5040000 5040000
Entry ticket price per
visitor (NPR) 242.55 254.68 267.41 280.78
Profit from sale of
Food and
Beverages per visitor
(NPR) 33.08 34.73 36.47 38.29
Profit from sale of
Fancy Gift Items per
visitor (NPR) 27.56 28.94 30.39 31.91
Revenue per visitor
(NPR) 303.19 318.35 334.27 350.98
Total Revenue (NPR

crores) 152.81 160.45 168.47 176.89
Less:
Annual Staffing Cost
(NPR crores) 71.66 75.25 79.01 82.96
Annual Insurance
Costs (NPR crores) 5.51 5.79 6.08 6.38
Other running and
maintenance
costs (NPR crores) 25.00 29.00 33.00 37.00
Depreciation
Allowances (NPR
crores) 40.00 32.00 25.60 20.48
Total Expenses (NPR
crores) 142.17 142.04 143.69 146.82
PBT (NPR crores) 10.64 18.41 24.78 30.07

Tax on Profit (NPR
crores) 2.13 3.68 4.96 6.01
Net Profit (NPR
crores) 8.51 14.73 19.82 24.06
Add: Depreciation
Allowances (NPR
crores) 40 32 25.6 20.48
Park Construction
Cost (NPR crores) -225 -225
After tax assets
realisation value
(NPR crores) 250
Working capital (NPR
crores) -65.00 -3.25 -3.41 -3.58 75.25
Net cash Flow (NPR
crores) -225.00 -290.00 45.26 43.32 41.84 369.79
PVF at discount rate 1.00 0.905 0.819 0.741 0.670 0.607
Present Values (NPR
crores) -225.00 -262.45 37.07 32.10 28.03 224.46
Net Present Value (NPR crores) -165.79
1.6.3 An Indian Company is investing in foreign country by raising fund in different
country through the mode of Global Depository Receipts (GDRs)
Illustration 3
Opus Technologies Ltd., an Indian IT company is planning to make an investment through a wholly
owned subsidiary in a software project in China with a shelf life of two years. The inflation in China
is estimated as 8 percent. Operating cash flows are received at the year end.
For the project an initial investment of Chinese Yuan (CN¥) 30,00,000 will be in land. The land will
be sold after the completion of project at estimated value of CN¥ 35,00,000. The project also
requires an office complex at cost of CN¥ 15,00,000 payable at the beginning of project. The
complex will be depreciated on straight-line basis over two years to a zero salvage value. This
complex is expected to fetch CN¥ 5,00,000 at the end of project.
The company is planning to raise the required funds through GDR issue in Mauritius. Each GDR
will have 5 common equity shares of the company as underlying security which are currently
trading at ` 200 per share (Face Value = `10) in the domestic market. The company has currently
paid the dividend of 25% which is expected to grow at 10% p.a. The total issue cost is estimated to
be 1 percent of issue size.
The annual sales is expected to be 10,000 units at the rate of CN¥ 500 per unit. The price of unit is
expected to rise at the rate of inflation. Variable operating costs are 40 percent of sales. Fixed
operating costs will be CN¥ 22,00,000 per year and expected to rise at the rate of inflation.
The tax rate applicable in China for income and capital gain is 25 percent and as per GOI Policy
no further tax shall be payable in India. The current spot rate of CN¥ 1 is ` 9.50. The nominal
interest rate in India and China is 12% and 10% respectively and the international parity conditions
hold
You are required to
(a) Identify expected future cash flows in China and determine NPV of the project in CN¥.
(b) Determine whether Opus Technologies should go for the project or not assuming that there
neither there is restriction on the transfer of funds from China to India nor any
charges/taxes payable on the transfer of funds.
Solution
Working Notes:
1. Calculation of Cost of Capital (GDR)
Current Dividend (D 0) 2.50

Expected Dividend (D1) 2.75
Net Proceeds (` 200 per share – 1%) 198.00
Growth Rate 10.00%
2.75
ke = + 0.10 = 0.1139 i.e. 11.39%
198
2. Calculation of Expected Exchange Rate as per Interest Rate Parity

YEAR EXPECTED RATE
1 (1 + 0.12)
= 9.50 × = 9.67
(1 + 0.10)
2 (1 + 0.12)2
= 9.50 × = 9.85
(1 + 0.10)2
3. Realization on the disposal of Land net of Tax

CN¥
Sale value at the end of project 3500000.00
Cost of Land 3000000.00
Capital Gain 500000.00
Tax paid 125000.00
Amount realized net of tax 3375000.00
4. Realization on the disposal of Office Complex
(CN¥)
Sale value at the end of project 500000.00
WDV 0.00
Capital Gain 500000.00
Tax paid 125000.00
Amount realized net of tax (A) 375000.00
5. Computation of Annual Cash Inflows
Year 1 2
Annual Units 10000 10000
Price per bottle (CN¥) 540.00 583.20
Annual Revenue (CN¥) 5400000.00 5832000.00
Less: Expenses
Variable operating cost (CN¥) 2160000.00 2332800.00
Depreciation (CN¥) 750000.00 750000.00
Fixed Cost per annum (CN¥) 2376000.00 2566080.00
PBT (CN¥) 114000.00 183120.00
Tax on Profit (CN¥) 28500.00 45780.00
Net Profit (CN¥) 85500.00 137340.00
Add: Depreciation (CN¥) 750000.00 750000.00
Cash Flow 835500.00 887340.00
(a) Computation of NPV of the project in CN¥

(CN¥)
Year 0 1 2
Initial Investment -4500000.00
Annual Cash Inflows 835500.00 887340.00
Realization on the disposal of
Land net of Tax 3375000.00
Realization on the disposal of
Office Complex 375000.00
Total -4500000.00 835500.00 4637340.00
PVF @11.39% 1.000 0.898 0.806
PV of Cash Flows -4500000.00 750279.00 3737696.00
NPV -12,025
(b) Evaluation of Project from Opus Point of View

(i) Assuming that inflow funds are transferred in the year in which same are
generated i.e. first year and second year.
Year 0 1 2
Cash Flows (CN¥) -4500000.00 835500.00 4637340.00
Exchange Rate (`/ CN¥) 9.50 9.67 9.85
Cash Flows (`) -42750000.00 8079285.00 45677799.00
PVF @ 12% 1.00 0.893 0.797
-42750000.00 7214802.00 36405206.00
NPV 870008.00
(ii) Assuming that inflow funds are transferred at the end of the project i.e.
second year.
Year 0 2
Cash Flows (CN¥) -4500000.00 5472840.00
Exchange Rate (`./ CN¥) 9.50 9.85
Cash Flows (`) -42750000.00 53907474.00
PVF 1.00 0.797
-42750000.00 42964257.00
NPV 214257.00
Though in terms of CN¥ the NPV of the project is negative but in Rs. it has positive NPV due to
weakening of Rs. in comparison of CN¥. Thus, Opus can accept the project.
2. INTERNATIONAL SOURCES OF FINANCE

Indian companies have been able to tap global markets to raise foreign currency funds by issuing
various types of financial instruments which are discussed as follows:
2.1 Foreign Currency Convertible Bonds (FCCBs)
A type of convertible bond issued in a currency different than the issuer's domestic currency. In
other words, the money being raised by the issuing company is in the form of a foreign currency. A
convertible bond is a mix between a debt and equity instrument. It acts like a bond by making
regular coupon and principal payments, but these bonds also give the bondholder the option to
convert the bond into stock.
These types of bonds are attractive to both investors and issuers. The investors receive the safety
of guaranteed payments on the bond and are also able to take advantage of any large price
appreciation in the company's stock. (Bondholders take advantage of this appreciation by means
of warrants attached to the bonds, which are activated when the price of the stock reaches a
certain point.) Due to the equity side of the bond, which adds value, the coupon payments on the
bond are lower for the company, thereby reducing its debt-financing costs.
Advantages of FCCBs
(i) The convertible bond gives the investor the flexibility to convert the bond into equity at a
price or redeem the bond at the end of a specified period, normally three years if the price
of the share has not met his expectations.
(ii) Companies prefer bonds as it leads to delayed dilution of equity and allows company to avoid
any current dilution in earnings per share that a further issuance of equity would cause.
(iii) FCCBs are easily marketable as investors enjoys option of conversion into equity if resulting to
capital appreciation. Further investor is assured of a minimum fixed interest earnings.
Disadvantages of FCCBs
(i) Exchange risk is more in FCCBs as interest on bonds would be payable in foreign currency.
Thus companies with low debt equity ratios, large forex earnings potential only opt for
FCCBs.
(ii) FCCBs mean creation of more debt and a forex outgo in terms of interest which is in foreign
exchange.
(iii) In the case of convertible bonds, the interest rate is low, say around 3–4% but there is
exchange risk on the interest payment as well as re-payment if the bonds are not converted
into equity shares. The only major advantage would be that where the company has a high
rate of growth in earnings and the conversion takes place subsequently, the price at which
shares can be issued can be higher than the current market price.
2.2 American Depository Receipts (ADRs)
Depository receipts issued by a company in the United States of America (USA) is known as American
Depository Receipts (ADRs). Such receipts must be issued in accordance with the provisions stipulated
by the Securities and Exchange Commission of USA (SEC) which are very stringent.
An ADR is generally created by the deposit of the securities of a non-United States company with
a custodian bank in the country of incorporation of the issuing company. The custodian bank
informs the depository in the United States that the ADRs can be issued. ADRs are United States
dollar denominated and are traded in the same way as are the securities of United States
companies. The ADR holder is entitled to the same rights and advantages as owners of the
underlying securities in the home country. Several variations on ADRs have developed ove r time
to meet more specialized demands in different markets. One such variation is the GDR which are
identical in structure to an ADR, the only difference being that they can be traded in more than one
currency and within as well as outside the United States.
2.3 Global Depository Receipts (GDRs)
A depository receipt is basically a negotiable certificate, denominated in a currency not native to
the issuer, that represents the company's publicly - traded local currency equity shares. Most
GDRs are denominated in USD, while a few are denominated in Euro and Pound Sterling. The
Depository Receipts issued in the US are called American Depository Receipts (ADRs), which
anyway are denominated in USD and outside of USA, these are called GDRs. In theory, though a
depository receipt can also represent a debt instrument, in practice it rarely does. DRs (depository
receipts) are created when the local currency shares of an Indian company are delivered to the
depository's local custodian bank, against which the Depository bank (such as the Bank of New
York) issues depository receipts in US dollar. These depository receipts may trade freely in the
overseas markets like any other dollar-denominated security, either on a foreign stock exchange,
or in the over-the-counter market, or among a restricted group such as Qualified Institutional
Buyers (QIBs). Indian issues have taken the form of GDRs to reflect the fact that they are
marketed globally, rather than in a specific country or market.
Through the issue of depository receipts, companies in India have been able to tap global equity
market to raise foreign currency funds by way of equity. Quite apart from the specific needs that
Indian companies may have for equity capital in preference to debt and the perceived advantage s
of raising equity over debt in general (no repayment of "principal" and generally lower servicing
costs, etc.) the fact of the matter is quite simple, that no other form of term foreign exchange
funding has been available. In addition, it has been perceived that a GDR issue has been able to
fetch higher prices from international investors (even when Indian issues were being sold at a
discount to the prevailing domestic share prices) than those that a domestic public issue would
have been able to extract from Indian investors.
• Impact of GDRs on Indian Capital Market

Since the inception of GDRs a remarkable change in Indian capital market has been
observed as follows:
(i) Indian stock market to some extent is shifting from Bombay to Luxemburg.
(ii) There is arbitrage possibility in GDR issues.
(iii) Indian stock market is no longer independent from the rest of the world. This puts
additional strain on the investors as they now need to keep updated with world wide
economic events.
(iv) Indian retail investors are completely sidelined. GDRs/Foreign Institutional Investors'
placements + free pricing implies that retail investors can no longer expect to make
easy money on heavily discounted rights/public issues.
As a result of introduction of GDRs a considerable foreign investment has flown into India.
• Markets of GDRs
(i) GDR's are sold primarily to institutional investors.
(ii) Demand is likely to be dominated by emerging market funds.
(iii) Switching by foreign institutional investors from ordinary shares int o GDRs is likely.
(iv) Major demand is also in UK, USA (Qualified Institutional Buyers), South East Asia
(Hong Kong, Singapore), and to some extent continental Europe (principally France
and Switzerland).
• Mechanism of GDR: The mechanics of a GDR issue may be described with the help of
following diagram.
Company issues
Ordinary shares
Kept with Custodian/depository banks
against which GDRs are issued
to Foreign investors
Characteristics
(i) Holders of GDRs participate in the economic benefits of being ordinary shareholders,
though they do not have voting rights.
(ii) GDRs are settled through CEDEL & Euro-clear international book entry systems.
(iii) GDRs are listed on the Luxemburg stock exchange.
(iv) Trading takes place between professional market makers on an OTC (over the counter) basis.
(v) The instruments are freely traded.
(vi) They are marketed globally without being confined to borders of any market or country as it
can be traded in more than one currency.
(vii) Investors earn fixed income by way of dividends which are paid in issuer currency converted into
dollars by depository and paid to investors and hence exchange risk is with investor.
(viii) As far as the case of liquidation of GDRs is concerned, an investor may get the GDR
cancelled any time after a cooling period of 45 days. A non-resident holder of GDRs may
ask the overseas bank (depository) to redeem (cancel) the GDRs In that case overseas
depository bank shall request the domestic custodians bank to cancel the GDR and to get
the corresponding underlying shares released in favour of non-resident investor. The price
of the ordinary shares of the issuing company prevailing in the Bombay Stock Exchange or
the National Stock Exchange on the date of advice of redemption shall be taken as the cost
of acquisition of the underlying ordinary share.
Illustration 4
X Ltd. is interested in expanding its operation and planning to install manufacturing plant at US.
For the proposed project it requires a fund of $ 10 million (net of issue expense s/ floatation cost).
The estimated floatation cost is 2%. To finance this project it proposes to issue GDRs.
You as financial consultant is required to compute the number of GDRs to be issued and cost of
the GDR with the help of following additional information.
(i) Expected market price of share at the time of issue of GDR is ` 250 (Face Value ` 100)
(ii) 2 Shares shall underly each GDR and shall be priced at 10% discount to market price.
(iii) Expected exchange rate ` 60/$.
(iv) Dividend expected to be paid is 20% with growth rate 12%.
Solution
Net Issue Size = $10 million
$10 million
Gross Issue = = $ 10.204 million
0.98
Issue Price per GDR in ` (250 x 2 x 90%) ` 450
Issue Price per GDR in $ (` 450/ ` 60) $ 7.50
Dividend Per GDR (D 1) (` 20 x 2) ` 40

Net Proceeds Per GDR (` 450 x 0.98) ` 441.00
$10.204 million
(a) Number of GDR to be issued = 1.3605 million
$7.50
40.00
(b) Cost of GDR to X Ltd. ke = + 0.12 = 21.07%
441.00
2.4 Euro-Convertible Bonds (ECBs)

A convertible bond is a debt instrument which gives the holders of the bond an option to convert
the bond into a predetermined number of equity shares of the company. Usually, the price of the
equity shares at the time of conversion will have a premium element. The bonds carry a fixed rate
of interest. If the issuer company desires, the issue of such bonds may carry two options viz.
(i) Call Options: (Issuer's option) - where the terms of issue of the bonds contain a provision
for call option, the issuer company has the option of calling (buying) the bonds for redemption
before the date of maturity of the bonds. Where the issuer's share price has appreciated
substantially, i.e. far in excess of the redemption value of the bonds, the issuer company can
exercise the option. This call option forces the investors to convert the bonds into equity. Usually,
such a case arises when the share prices reach a stage near 130% to 150% of the conversion
price.
(ii) Put options - A provision of put option gives the holder of the bonds a right to put (sell)his
bonds back to the issuer company at a pre-determined price and date. In case of Euro-convertible
bonds, the payment of interest on and the redemption of the bonds will be made by the issuer
company in US dollars.
2.5 Other Sources
• Euro Bonds: Plain Euro-bonds are nothing but debt instruments. These are not very
attractive for an investor who desires to have valuable additions to his investments.
• Euro-Convertible Zero Bonds: These bonds are structured as a convertible bond. No
interest is payable on the bonds. But conversion of bonds takes place on maturity at a pre-
determined price. Usually there is a 5 years maturity period and they are treated as a
deferred equity issue.
• Euro-bonds with Equity Warrants: These bonds carry a coupon rate determined by the
market rates. The warrants are detachable. Pure bonds are traded at a discount. Fixed
income funds' managements may like to invest for the purposes of regular income.
• Syndicated bank loans: One of the earlier ways of raising funds in the form of large loans
from banks with good credit rating, can be arranged in reasonably short time and with few
formalities. The maturity of the loan can be for a duration of 5 to 10 years. The interest rate
is generally set with reference to an index, say, LIBOR plus a spread which depends upon
the credit rating of the borrower. Some covenants are laid down by the lending institution
like maintenance of key financial ratios.
• Euro-bonds: These are basically debt instruments denominated in a currency issued
outside the country of that currency for examples Yen bond floated in France. Primary
attraction of these bonds is the refuge from tax and regulations and provide scope for
arbitraging yields. These are usually bearer bonds and can take the form of
(i) Traditional Fixed Rate Bonds.
(ii) Floating Rate Notes (FRNs)
(iii) Convertible Bonds.
• Foreign Bonds: Foreign bonds are denominated in a currency which is foreign to the
borrower and sold at the country of that currency. Such bonds are always subject to the
restrictions and are placed by that country on the foreigners funds.
• Euro Commercial Papers: These are short term money market securities usually issued at
a discount, for maturities less than one year.
• Credit Instruments: The foregoing discussion relating to foreign exchange risk
management and international capital market shows that foreign exchange operations of
banks consist primarily of purchase and sale of credit instruments. There are many types of
credit instruments used in effecting foreign remittances. They differ in the speed, with which
money can be received by the creditor at the other end after it has been paid in by the
debtor at his end. The price or the rate of each instrument, therefore, varies with extent of
the loss of interest and risk of loss involved. There are, therefore, different rates of
exchange applicable to different types of credit instruments.
3. INTERNATIONAL WORKING CAPITAL MANAGEMENT

The management of working capital in an international firm is much more complex as compared to
a domestic one. The reasons for such complexity are:
(1) A multinational firm has a wider option for financing its current assets. A MNC has funds
flowing in from different parts of international financial markets. Therefore, it may choose to
avail financing either locally or from global financial markets. Such an opportunity does not
exist for pure domestic firms.
(2) Interest and tax rates vary from one country to the other. A Treasurer associated with a
multinational firm has to consider the interest/ tax rate differentials while financing current
assets. This is not the case for domestic firms.
(3) A multinational firm is confronted with foreign exchange risk due to the value of
inflow/outflow of funds as well as the value of import/export are influenced by exchange rate
variations.
(4) Restrictions imposed by the home or host country government towards movement of cash
and inventory on account of political considerations affect the growth of MNCs. Domestic
firm limit their operations within the country and do not face such problems.
(5) With limited knowledge of the politico-economic conditions prevailing in different host
countries, a Manager of a multinational firm often finds it difficult to manage working capital
of different units of the firm operating in these countries. The pace of development taking
place in the communication system has to some extent eased this problem .
(6) In countries which operate on full capital convertibility, a MNC can move its funds from one
location to another and thus mobilize and ‘position’ the funds in the most efficient way
possible. Such freedom may not be available for MNCs operating in countries that have not
subscribed to full capital convertibility (like India).
A study of International Working Capital Management requires knowledge of Multinational Cash
Management, International Inventory Management and International Receivables Management.
3.1 Multinational Cash Management
MNCs are very much concerned for effective cash management. International money managers
follow the traditional objectives of cash management viz.
(1) Effectively managing and controlling cash resources of the company as well as
(2) Achieving optimum utilization and conservation of funds.
The former objective can be attained by improving cash collections and disbursements and by
making an accurate and timely forecast of cash flow pattern. The latter objective can be reached
by making money available as and when needed, minimising the cash balance level and
increasing the risk adjusted return on funds that is to be invested.
International Cash Management requires Multinational firms to adhere to the extant rules and
regulations in various countries that they operate in. Apart from these rules and regulations, they
would be required to follow the relevant forex market practices and conventions which may not be
practiced in their parent countries. A host of factors curtail the area of operations of an
international money manager e.g. restrictions on FDI, repatriation of foreign sales proceeds to the
home country within a specified time limit and the, problem of blocked funds. Such restrictions
hinder the movement of funds across national borders and the manager has to plan beforehand
the possibility of such situation arising on a country to country basis. Other complications in the
form of multiple tax jurisdictions and currencies and absence of internationally integrated
exchange facilities result in shifting of cash from one location to another to overcome these
difficulties.
The main objectives of an effective system of international cash management are:
(1) To minimise currency exposure risk.
(2) To minimise overall cash requirements of the company as a whole without disturbing
smooth operations of the subsidiary or its affiliate.
(3) To minimise transaction costs.
(4) To minimise country’s political risk.
(5) To take advantage of economies of scale as well as reap benefits of superior knowledge.
The objectives are conflicting in nature as minimising of transaction costs require cash balance to
be kept in the currency in which they are received thereby contradicting both currency and political
exposure requirements.
A centralized cash management group is required to monitor and manage parent subsidiary and
inter-subsidiary cash flows. Centralization needs centralization of information, reports and decision
making process relating to cash mobilisation, movement and investment. This system benefits
individual subsidiaries which require funds or are exposed to exchange rate risk.
A centralised cash system helps MNCs as follows:
(a) To maintain minimum cash balance during the year.
(b) To manage judiciously liquidity requirements of the centre.
(c) To optimally use various hedging strategies so that MNC’s foreign exchange exposure is
minimised.
(d) To aid the centre to generate maximum returns by investing all cash resources optimally.
(e) To aid the centre to take advantage of multinational netting so that transaction costs and
currency exposure are minimised.
(f) To make maximum utilization of transfer pricing mechanism so that the firm enhances its
profitability and growth.
(g) To exploit currency movement correlations:
(i) Payables & receivables in different currencies having positive correlat ions.
(ii) Payables of different currencies having negative correlations.
(iii) Pooling of funds allows for reduced holding – the variance of the total cash flows for
the entire group will be smaller than the sum of the individual variances .
Consider an MNC with two subsidiaries in different countries. The two subsidiaries periodically
send fees and dividends to the parent as well as send excess cash – all of them represent
incoming cash to the parent while the cash outflows to the subsidiaries include loans and return on
cash invested by them. As subsidiaries purchase supplies from each other they have cash flows
between themselves.
Interest and/or principal on

excess cash invested by
Purchase of Securities
subsidiary
Short Term
Loans Funds received Securities

from
Subsidiary A Sale of securities
Excess Cash
Long Term
to be Long Term
invested Investment
Project
Funds Funds Loans Sources of
for for Parent Debt
Supplier
s Suppliers
Repayment on Loans
Excess Cash
Funds paid for
to be new stock issues
Subsidiary B invested
Fees and part of
Sources of
earnings Debt
Cash Dividends
Interest and/or principal on
excess cash invested by subsidiary
Loans
Cash Flow of the Overall MNC
International Cash Management has two basic objectives:
1. Optimising Cash Flow movements.
2. Investing excess cash.
As no single strategy of international cash management can help in achieving both these
objectives together, its task on such aspects becomes very challenging.
There are numerous ways of optimising cash inflows:
1. Accelerating Cash Inflows.
2. Managing Blocked Funds.
3. Leading and Lagging strategy.
4. Minimising tax on cash flow through International Transfer Pricing.
5. Using netting to reduce overall transaction costs by eliminating number of unnecessary

conversions and transfer of currencies (Netting).
6. Investing Excess Cash
3.1.1 Accelerating Cash Inflows
Faster recovery of cash inflows helps the firm to use them whenever required or to invest them for
better returns. Customers if using cheques for making payments, all over the world are instructed
to send their payments to lockboxes set up at various locations, thereby reducing the time and
transaction costs involved in collecting payments. Also, through pre-authorized payment, an
organization may be allowed to charge the customer’s bank account up to some limit.
3.1.2 Managing Blocked Funds
The host country may block funds of the subsidiary to be sent to the parent or make sure that
earnings generated by the subsidiary be reinvested locally before being remitted to the parent so
that jobs are created and unemployment reduced. The subsidiary may be instructed to obtain bank
finance locally for the parent firm so that blocked funds may be utilised to pay off bank loans.
The parent company has to assess the potential of future funds blockage in a foreign count ry.
MNCs have to be aware of political risks cropping up due to unexpected blockage of funds and
devise ways to benefit their shareholders by using different methods for moving blocked funds
through transfer pricing strategies, direct negotiations, leading and lagging and so on.
3.1.3 Leading and Lagging
This technique is used by subsidiaries for optimizing cash flow movements by adjusting the timing of
payments to determine expectations about future currency movements. MNCs accelerate (lead) or
delay (lag) the timing of foreign currency payments through adjustment of the credit terms extended
by one unit to another. This technique helps to reduce foreign exchange exposure or to increase
available working capital. Firms accelerate payments of hard currency payables and delay payments
of soft currency payables in order to reduce foreign exchange exposure. Suppose an MNC in the
USA has subsidiaries all over the world. The subsidiary in India purchases its supplies from another
subsidiary in Japan. If the Indian subsidiary expects the rupee to fall against the yen, then it shall be
the objective of that firm to accelerate the timing of its payment before the rupee depreciates. Such a
strategy is called Leading. On the other hand, if the Indian subsidiary expects the rupee further to be
stronger against the yen then it shall be the objective of that firm to delay the timing of its payment
before the rupee appreciates. Such a strategy is called Lagging. MNCs should be aware of the
government restrictions in such countries before availing such strategies.
3.1.4 Minimising Tax on Cash Flows through Transfer Pricing
Mechanism
Large entities having many divisions require goods and services to be transferred frequently from
one division to another. The profits of different divisions are determined by the price to be charged
by the transferor division to the transferee division. The higher the transfer price, the larger will be
the gross profit of the transferor division with respect to the transferee division. The positio n gets
complicated for MNCs due to exchange restrictions, inflation differentials, import duties, tax rate
differentials between two nations, quotas imposed by host country, etc.
3.1.5 Netting
It is a technique of optimising cash flow movements with the combined efforts of the subsidiaries
thereby reducing administrative and transaction costs resulting from currency conversion. There is
a co-ordinated international interchange of materials, finished products and parts among the
different units of MNC with many subsidiaries buying /selling from/to each other. Netting helps in
minimising the total volume of inter-company fund flow.
Advantages derived from netting system includes:
1) Reduces the number of cross-border transactions between subsidiaries thereby decreasing
the overall administrative costs of such cash transfers
2) Reduces the need for foreign exchange conversion and hence decreases transaction costs
associated with foreign exchange conversion.
3) Improves cash flow forecasting since net cash transfers are made at the end of each period
4) Gives an accurate report and settles accounts through co-ordinated efforts among all
subsidiaries.
There are two types of Netting:
1. Bilateral Netting System – It involves transactions between the parent and a subsidiary or
between two subsidiaries. If subsidiary X purchases $ 20 million worth of goods from
subsidiary Y and subsidiary Y in turn buy $ 30 million worth of goods from subsidiary X,
then the combined flows add up to $ 50 million. But in bilateral netting system subsidiary Y
would pay subsidiary X only $10 million. Thus, bilateral netting reduces the number of
foreign exchange transactions and also the costs associated with foreign exchange
conversion. A more complex situation arises among the parent firm and sev eral subsidiaries
paving the way to multinational netting system.
2. Multilateral Netting System – Each affiliate nets all its inter affiliate receipts against all its
disbursements. It transfers or receives the balance on the position of it being a net re ceiver
or a payer thereby resulting in savings in transfer / exchange costs. For an effective
multilateral netting system, these should be a centralised communication system along with
disciplined subsidiaries. This type of system calls for the consolidation of information and
net cash flow positions for each pair of subsidiaries.
Subsidiary P sells $ 50 million worth of goods to Subsidiary Q, Subsidiary Q sells $ 50 million
worth of goods to Subsidiary R and Subsidiary R sells $ 50 million worth of goods t o Subsidiary P.
Through multilateral netting inter affiliate fund transfers are completely eliminated.
$ 50 $ 50
million
million
Q $ 50 R
million
The netting system uses a matrix of receivables and payables to determine the net receipt / net
payment position of each affiliate at the date of clearing. A US parent company has subsidiaries in
France, Germany, UK and Italy. The amounts due to and from the affiliates is converted into a
common currency viz. US dollar and entered in the following matrix.
Inter Subsidiary Payments Matrix (US $ Thousands)
Paying affiliate
France Germany UK Italy Total
France --- 40 60 100 200
Germany 60 --- 40 80 180
Receiving affiliate UK 80 60 --- 70 210
Italy 100 30 60 --- 190
Total 240 130 160 250 780
Without netting, the total payments are $ 780 Thousands. Through multinational netting these
transfers will be reduced to $ 100 Thousands, a net reduction of 87%. Also currency conversion
costs are significantly reduced. The transformed matrix after consolidation and net payments in
both directions convert all figures to US dollar equivalents to the below form:
Netting Schedule (US $ Thousands)
Receipt Payment Net Receipt Net Payments
France 200 240 --- 40
Germany 180 130 50 ---
UK 210 160 50 ---
Italy 190 250 --- 60
100 100
3.1.6 Investing Excess Cash

Euro Currency market accommodates excess cash in international money market. Euro Dollar
deposits offer MNCs higher yield than bank deposits in US. The MNCs use the Euro Currency
market for temporary use of funds, purchase of foreign treasury bills / commercial paper. Through
better telecommunication system and integration of various money markets in different countries,
access to the securities in foreign markets has become easier.
Through a centralized cash management strategy, MNCs pool together excess funds from
subsidiaries enabling them to earn higher returns due to the larger deposits lying with them.
Sometimes a separate investment account is maintained for all subsidiaries so that short term
financing needs of one can be met by the other subsidiary without incurring transaction costs
charged by banks for exchanging currencies. Such an approach leads to an excessive transaction
costs. The centralized system helps to convert the excess funds pooled together into a singl e
currency for investments thereby involving considerable transaction cost and a cost benefit
analysis should be made to find out whether the benefits reaped are not offset by the transaction
costs incurred. A question may arise as to how MNCs will utilise their excess funds once they have
used them to meet short term financing needs. This is vital since some currencies may provide a
higher interest rate or may appreciate considerably. So deposits made in such currencies will be
attractive. Again MNCs may go in for foreign currency deposit which may give an effective yield
higher than domestic deposit so as to overcome exchange rate risk. Forecasting of exchange rate
fluctuations need to be calculated in this respect so that a comparative study can be effect ively
made. Lastly an MNC can go for a diversification of its portfolio in different countries having
different currencies because of the exchange rate fluctuations taking place and at the same time
avoid the possibility of incurring substantial losses that may arise due to sudden currency
depreciation.
3.2 International Inventory Management
An international firm possesses normally a bigger stock than EOQ and this process is known as
stock piling. The different units of a firm get a large part of their inventory from sister units in
different countries. This is possible in a vertical set up. For political disturbance there will be
bottlenecks in import. If the currency of the importing country depreciates, imports will be costlier
thereby giving rise to stock piling. To take a decision against stock piling the firm has to weigh the
cumulative carrying cost vis-à-vis expected increase in the price of input due to changes in
exchange rate. If the probability of interruption in supply is very high, the firm may opt for stock
piling even if it is not justified on account of higher cost.
Also in case of global firms, lead time is larger on various units as they are located far off in
different parts of the globe. Even if they reach the port in time, a lot of custo ms formalities have to
be carried out. Due to these factors, re-order point for international firm lies much earlier. The final
decision depends on the quantity of goods to be imported and how much of them are locally
available. Relying on imports varies from unit to unit but it is very much large for a vertical set up.
3.3 International Receivables Management
Credit Sales lead to the emergence of account receivables. There are two types of such sales viz.
Inter firm Sales and Intra firm Sales in the global aspect.
In case of Inter firm Sales, the currency in which the transaction should be denominated and the
terms of payment need proper attention. With regard to currency denomination, the exporter is
interested to denominate the transaction in a strong currency while the importer wants to get it
denominated in weak currency. The exporter may be willing to invoice the transaction in the weak
currency even for a long period if it has debt in that currency. This is due to sale proceeds being
used to retire debts without loss on account of exchange rate changes. With regard to terms of
payment, the exporter does not provide a longer period of credit and ventures to get the export
proceeds quickly in order to invoice the transaction in a weak currency. If the c redit term is liberal the
exporter is able to borrow currency from the bank on the basis of bills receivables. Also credit terms
may be liberal in cases where competition in the market is keen compelling the exporter to finance a
part of the importer’s inventory. Such an action from the exporter helps to expand sales in a big way.
In case of Intra firm sales, the focus is on global allocation of firm’s resources. Different parts of
the same product are produced in different units established in different co untries and exported to
the assembly units leading to a large size of receivables. The question of quick or delayed
payment does not affect the firm as both the seller and the buyer are from the same firm though
the one having cash surplus will make early payments while the other having cash crunch will
make late payments. This is a case of intra firm allocation of resources where leads and lags
explained earlier will be taken recourse to.
TEST YOUR KNOWLEDGE

1. Write a short note on Instruments of International Finance.
2. What is the impact of GDRs on Indian Capital Market?
Practical Questions
1. ABC Ltd. is considering a project in US, which will involve an initial investment of
US $ 1,10,00,000. The project will have 5 years of life. Current spot exchange rate is ` 48
per US $. The risk free rate in US is 8% and the same in India is 12%. Cash inflow from the
project is as follows:
Year Cash inflow
1 US $ 20,00,000
2 US $ 25,00,000
3 US $ 30,00,000
4 US $ 40,00,000
5 US $ 50,00,000
Calculate the NPV of the project using foreign currency approach. Required rate of return
on this project is 14%.
2. A USA based company is planning to set up a software development unit in India. Software
developed at the Indian unit will be bought back by the US parent at a transfer price of US
$10 millions. The unit will remain in existence in India for one year; the software is expected
to get developed within this time frame.
The US based company will be subject to corporate tax of 30 per cent and a withholding tax
of 10 per cent in India and will not be eligible for tax credit in the US. The software
developed will be sold in the US market for US $ 12.0 millions. Other estimates are as
follows:
Rent for fully furnished unit with necessary hardware in India ` 15,00,000
Man power cost (80 software professional will be working for 10 ` 400 per man hour
hours each day)
Administrative and other costs ` 12,00,000
Advise the US Company on the financial viability of the project. The rupee-dollar rate is
`48/$.
Note: Assume 365 days a year.
3. XY Limited is engaged in large retail business in India. It is contemplating for expansion
into a country of Africa by acquiring a group of stores having the same line of operation
as that of India.
The exchange rate for the currency of the proposed African country is extremely volatile.
Rate of inflation is presently 40% a year. Inflation in India is currently 10% a year.
Management of XY Limited expects these rates likely to continue for the foreseeable
future.
Estimated projected cash flows, in real terms, in India as well as African country for
the first three years of the project are as follows:
Year – 0 Year – 1 Year – 2 Year - 3
Cash flows in Indian -50,000 -1,500 -2,000 -2,500
` (000)
Cash flows in African -2,00,000 +50,000 +70,000 +90,000
Rands (000)
XY Ltd. assumes the year 3 nominal cash flows will continue to be earned each year
indefinitely. It evaluates all investments using nominal cash flows and a nominal
discounting rate. The present exchange rate is African Rand 6 to ` 1.
You are required to calculate the net present value of the proposed investment considering
the following:
(i) African Rand cash flows are converted into rupees and discounted at a risk
adjusted rate.
(ii) All cash flows for these projects will be discounted at a rate of 20% to reflect it’s
high risk.
(iii) Ignore taxation.
Year - 1 Year - 2 Year - 3
PVIF @ 20% .833 .694 .579
4. A multinational company is planning to set up a subsidiary company in India (where hitherto
it was exporting) in view of growing demand for its product and competition from other
MNCs. The initial project cost (consisting of Plant and Machinery including installation) is
estimated to be US$ 500 million. The net working capital requirements are estimated at
US$ 50 million. The company follows straight line method of depreciation. Presently, the
company is exporting two million units every year at a unit price of US$ 80, its variable cost
per unit being US$ 40.
The Chief Financial Officer has estimated the following operating cost and other data in
respect of proposed project:
(i) Variable operating cost will be US $ 20 per unit of production;
(ii) Additional cash fixed cost will be US $ 30 million p.a. and project's share of allocated
fixed cost will be US $ 3 million p.a. based on principle of ability to share;
(iii) Production capacity of the proposed project in India will be 5 million units;
(iv) Expected useful life of the proposed plant is five years with no salvage val ue;
(v) Existing working capital investment for production & sale of two million units through
exports was US $ 15 million;
(vi) Export of the product in the coming year will decrease to 1.5 million units in case the
company does not open subsidiary company in India, in view of the presence of
competing MNCs that are in the process of setting up their subsidiaries in India;
(vii) Applicable Corporate Income Tax rate is 35%, and
(viii) Required rate of return for such project is 12%.
Assuming that there will be no variation in the exchange rate of two currencies and all
profits will be repatriated, as there will be no withholding tax, estimate Net Present Value
(NPV) of the proposed project in India.
Present Value Interest Factors (PVIF) @ 12% for five years are as below:
Year 1 2 3 4 5
PVIF 0.8929 0.7972 0.7118 0.6355 0.5674
5. XYZ Ltd., a company based in India, manufactures very high quality modem furniture and
sells to a small number of retail outlets in India and Nepal. It is facing tough competit ion.
Recent studies on marketability of products have clearly indicated that the customer is now
more interested in variety and choice rather than exclusivity and exceptional quality. Since
the cost of quality wood in India is very high, the company is reviewing the proposal for
import of woods in bulk from Nepalese supplier.
The estimate of net Indian (`) and Nepalese Currency (NC) cash flows in Nominal terms for
this proposal is shown below:
Net Cash Flow (in millions)
Year 0 1 2 3
NC -25.000 2.600 3.800 4.100
Indian (`) 0 2.869 4.200 4.600
The following information is relevant:
(i) XYZ Ltd. evaluates all investments by using a discount rate of 9% p.a. All Nepalese
customers are invoiced in NC. NC cash flows are converted to Indian (`) at the
forward rate and discounted at the Indian rate.
(ii) Inflation rates in Nepal and India are expected to be 9% and 8% p.a. respectively.
The current exchange rate is ` 1= NC 1.6
Assuming that you are the finance manager of XYZ Ltd., calculate the net present val ue
(NPV) and modified internal rate of return (MIRR) of the proposal.
You may use following values with respect to discount factor for ` 1 @9%.
Present Value Future Value
Year 1 0.917 1.188
Year 2 0.842 1.090
Year 3 0.772 1
ANSWERS/ SOLUTIONS

1. (1 + 0.12) (1 + Risk Premium) = (1 + 0.14)
Or, 1 + Risk Premium = 1.14/1.12 = 1.0179
Therefore, Risk adjusted dollar rate is = 1.0179 x 1.08 = 1.099 – 1 = 0.099
Calculation of NPV
Year Cash flow PV Factor at 9.9% P.V.
(Million)
US$
1 2.00 0.910 1.820
2 2.50 0.828 2.070
3 3.00 0.753 2.259
4 4.00 0.686 2.744
5 5.00 0.624 3.120
12.013
Less: Investment 11.000
NPV 1.013
Therefore, Rupee NPV of the project is = ` (48 x 1.013) Million= `48.624 Million
2. Proforma profit and loss account of the Indian software development unit
` `
Revenue 48,00,00,000
Less: Costs:
Rent 15,00,000
Manpower (`400 x 80 x 10 x 365) 11,68,00,000
Administrative and other costs 12,00,000 11,95,00,000
Earnings before tax 36,05,00,000
Less: Tax 10,81,50,000
Earnings after tax 25,23,50,000
Less: Withholding tax(TDS) 2,52,35,000
Repatriation amount (in rupees) 22,71,15,000
Repatriation amount (in dollars) $4.7 million
Advise: The cost of development software in India for the US based company is $5.268
million. As the USA based Company is expected to sell the software in the US at $12.0
million, it is advised to develop the software in India.
Alternatively, if is assumed that since foreign subsidiary has paid taxes it will not pay
withholding taxes then solution will be as under:
` `
Revenue 48,00,00,000
Less: Costs:
Rent 15,00,000
Manpower (`400 x 80 x 10 x 365) 11,68,00,000
Less: Tax 10,81,50,000
Earnings after tax 25,23,50,000
Repatriation amount (in dollars) $ 5,257,292
Alternatively, if it assumed that first the withholding tax @ 10% is being paid and then
its credit is taken in the payment of corporate tax then solution will be as follows:
` `
Revenue 48,00,00,000
Less: Costs:
Rent 15,00,000
Manpower (`400 x 80 x 10 x 365) 11,68,00,000
Less: Withholding Tax 3,60,50,000
Earnings after Withholding tax @ 10% 32,44,50,000
Less: Corporation Tax net of Withholding Tax 7,21,00,000
Repatriation amount (in dollars) $ 5,257,292
3. Calculation of NPV
Year 0 1 2 3
Inflation factor in India 1.00 1.10 1.21 1.331
Inflation factor in Africa 1.00 1.40 1.96 2.744
Exchange Rate (as per IRP) 6.00 7.6364 9.7190 12.3696
Cash Flows in ` ’000
Real -50000 -1500 -2000 -2500

Nominal (1) -50000 -1650 -2420 -3327.50
Cash Flows in African Rand ’000
Real -200000 50000 70000 90000
Nominal -200000 70000 137200 246960
In Indian ` ’000 (2) -33333 9167 14117 19965
Net Cash Flow in ` ‘000 (1)+(2) -83333 7517 11697 16637
PVF@20% 1 0.833 0.694 0.579
PV -83333 6262 8118 9633
NPV of 3 years = -59320 (` ‘000)
16637
NPV of Terminal Value = × 0.579 = 48164 ( ` ’000)
0.20
Total NPV of the Project = -59320 (` ‘000) + 48164 ( ` ’000) = -11156 ( ` ’000)
4. Financial Analysis whether to set up the manufacturing units in India or not may be carried
using NPV technique as follows:
I. Incremental Cash Outflows
$ Million
Cost of Plant and Machinery 500.00
Working Capital 50.00
Release of existing Working Capital (15.00)
535.00
II. Incremental Cash Inflow after Tax (CFAT)
(a) Generated by investment in India for 5 years
$ Million
Sales Revenue (5 Million x $80) 400.00
Less: Costs
Variable Cost (5 Million x $20) 100.00
Fixed Cost 30.00
Depreciation ($500Million/5) 100.00
EBIT 170.00
Taxes@35% 59.50
EAT 110.50
Add: Depreciation 100.00
CFAT (1-5 years) 210.50
(b) Cash flow at the end of the 5 years (Release of Working Capital) 35.00
(c) Cash generation by exports (Opportunity Cost)

$ Million
Sales Revenue (1.5 Million x $80) 120.00
Less: Variable Cost (1.5 Million x $40) 60.00
Contribution before tax 60.00
Tax@35% 21.00
CFAT (1-5 years) 39.00
(d) Additional CFAT attributable to Foreign Investment
$ Million
Through setting up subsidiary in India 210.50
Through Exports in India 39.00
CFAT (1-5 years) 171.50
III. Determination of NPV
Year CFAT ($ Million) PVF@12% PV ($ Million)
1-5 171.50 3.6048 618.2232
5 35 0.5674 19.8590
638.0822
Less: Initial Outflow 535.0000
103.0822
Since NPV is positive the proposal should be accepted.

5. Working Notes:
(i) Computation of Forward Rates
End of Year NC NC/`
1  (1 + 0.09 ) 
NC1.60 x 
 (1 + 0.08 )  1.615
 
2  (1 + 0.09 ) 
NC1.615 x 
 (1 + 0.08 )  1.630
 
3  (1 + 0.09 ) 
NC1.630 x 
 (1 + 0.08 )  1.645
 
(ii) NC Cash Flows converted in Indian Rupees

Year NC (Million) Conversion Rate ` (Million)
0 -25.00 1.600 -15.625
1 2.60 1.615 1.61
2 3.80 1.630 2.33
3 4.10 1.645 2.49
Net Present Value
(` Million)
Year Cash Cash Flow Total PVF PV
Flow in in Nepal @ 9%
India
0 --- -15.625 -15.625 1.000 -15.625
1 2.869 1.61 4.479 0.917 4.107
2 4.200 2.33 6.53 0.842 5.498
3 4.600 2.49 7.09 0.772 5.473
-0.547
Modified Internal Rate of Return

Year
0 1 2 3
Cash Flow (` Million) -15.625 4.479 6.53 7.09
Year 1 Cash Inflow reinvested for 2 5.32
years (1.188 x 4.479)
Year 2 Cash Inflow reinvested for 1 7.12
years (1.090 x 6.53)
19.53
TerminalCashFlow 19.53
MIRR = n −1= 3 − 1 = 0.0772 say 7.72%
InitialOutlay 15.625
11
INTEREST RATE RISK

MANAGEMENT
LEARNING OUTCOMES
❑ Interest Rate Risk
❑ Hedging Interest Rate Risk
(a) Traditional Methods
(b) Modern Methods including Interest Rate Derivatives
1. INTRODUCTION
Companies with low profit margins and high capital expenses may be extremely sensitive to
interest rate increases. Interest rate derivatives are valuable tools in managing risks. Derivatives
are powerful tools that mitigate risk and build value. They help companies to develop a risk
mitigation strategy.
Interest rate is the cost of borrowing money and the compensation for the service and risk of
lending money. Interest rates are always changing, and different types of loans offer various
interest rates. The lender of money takes a risk because the borrower may not pay back the loan.
Thus, interest provides a certain compensation for bearing risk.
Coupled with the risk of default is the risk of inflation. When you lend money now, the price s of
goods and services may go up by the time you are paid back, so your money's original purchasing
power would decrease. Thus, interest protects against future rises in inflation. A lender such as a
bank uses the interest to process account costs as well.
1.1 How interest rates are determined

The factors affecting interest rates are largely macro-economic in nature:
(a) Demand/supply of money- When economic growth is high, demand for money increases,
pushing the interest rates up and vice versa.
(b) Inflation - The higher the inflation rate, the more interest rates are likely to rise.
(c) Government- Government is the biggest borrower. The level of borrowing also determines
the interest rates. Central Bank i.e. RBI by either printing more notes or through its Open
Market Operations (OMO) changes the key rates (CRR, SLR and bank rates) depending on
the state of the economy or to combat inflation.
1.2 Interest Rate Risk
Interest risk is the change in prices of bonds that could occur because of change in interest rates.
It also considers change in impact on interest income due to changes in the rate of interest. In
other words, price as well as reinvestment risks require focus. So far as the terms for which
interest rates were fixed on deposits banks incurs interest rate risk i.e., they stood to make gains
or losses with every change in the level of interest rates.
1.3 Types of Interest Rate Risk
Various types of Interest rate risk faced by companies/ banks are as follows:
1.3.1 Gap Exposure
A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet items with
different principal amounts, maturity dates or re-pricing dates, thereby creating exposure to
unexpected changes in the level of market interest rates. This exposure is more important in
relation to banking business.
The positive Gap indicates that banks have more interest Rate Sensitive Assets (RSAs) than
interest Rate Sensitive Liabilities (RSLs). A positive or asset sensitive Gap means that an increase
in market interest rates could cause an increase in Net Interest Income (NII). Conversely, a
negative or liability sensitive Gap implies that the banks’ NII could decline as a result of decrease
in market interest rates.
A negative gap indicates that banks have more RSLs than RSAs. The Gap is used as a measure
of interest rate sensitivity.
Positive or Negative Gap is multiplied by the assumed interest rate changes to derive the Earnings
at Risk (EaR). The EaR method facilitates to estimate how much the earnings might be imp acted
by an adverse movement in interest rates. The changes in interest rate could be estimated on the
basis of past trends, forecasting of interest rates, etc. The banks should fix EaR which could be
based on last/current year’s income and a trigger point at which the line management should adopt
on-or off-balance sheet hedging strategies may be clearly defined.
INTEREST RATE RISK MANAGEMENT 711.3
Gap calculations can be augmented by information on the average coupon on assets and liabilities
in each time band and the same could be used to calculate estimates of the level of NII from
positions maturing or due for repricing within a given time-band, which would then provide a scale
to assess the changes in income implied by the gap analysis.
The periodic gap analysis indicates the interest rate risk exposure of banks over distinct maturities
and suggests magnitude of portfolio changes necessary to alter the risk profile.
Although the Gap Report is very useful for analysis of Risk but it also suffers from following
limitations:
❖ The Gap report quantifies only the time difference between re-pricing dates of assets and
liabilities but fails to measure the impact of basis and embedded option risks.
❖ The Gap report also fails to measure the entire impact of a change in interest rate (Gap
report assumes that all assets and liabilities are matured or re-priced simultaneously) within
a given time-band and effect of changes in interest rates on the economic or market value
of assets, liabilities and off-balance sheet position.
❖ It also does not take into account any differences in the timing of payments that might occur
as a result of changes in interest rate environment.
❖ Further, the assumption of parallel shift in yield curves seldom happen in the financial
market.
❖ The Gap report also fails to capture variability in non-interest revenue and expenses, a
potentially important source of risk to current income.
1.3.2 Basis Risk
Market interest rates of various instruments seldom change by the same degree during a given
period of time. The risk that the interest rate of different assets, liabilities and off-balance sheet
items may change in different magnitude is termed as basis risk. For example, while assets may
be benchmarked to Fixed Rate of Interest, liabilities may be benchmarked to floating rate of
interest. The degree of basis risk is fairly high in respect of banks that create composite assets out
of composite liabilities. The Loan book in India is funded out of a composite liability portfolio and is
exposed to a considerable degree of basis risk. The basis risk is quite visible in volatile interest
rate scenarios.
When the variation in market interest rate causes the NII to expand, the banks have experienced
favourable basis shifts and if the interest rate movement causes the NII to contract, the basis has
moved against the banks.
1.3.3 Embedded Option Risk
Significant changes in market interest rates create another source of risk to banks’ profitability by
encouraging prepayment of cash credit/demand loans/term loans and exercise of call/put opt ions
on bonds/debentures and/or premature withdrawal of term deposits before their stated maturities.
The embedded option risk is becoming a reality in India and is experienced in volatile situations.
The faster and higher the magnitude of changes in interest rate, the greater will be the embedded
option risk to the banks’ NII. Thus, banks should evolve scientific techniques to estimate the
probable embedded options and adjust the Gap statements (Liquidity and Interest Rate Sensitivity)
to realistically estimate the risk profiles in their balance sheet. Banks should also endeavour to
stipulate appropriate penalties based on opportunity costs to stem the exercise of options, which is
always to the disadvantage of banks.
1.3.4 Yield Curve Risk
The movements in yield curve are rather frequent when the economy moves through business
cycles. Thus, banks should evaluate the movement in yield curves and the impact of that on the
portfolio values and income.
1.3.5 Price Risk
Price risk occurs when assets are sold before their stated maturities. In the financial market, bond
prices and yields are inversely related. The price risk is closely associated with the trading book,
which is created for making profit out of short-term movements in interest rates.
Banks which have an active trading book should, therefore, formulate policies to limit the portfolio
size, holding period, duration, defeasance period, stop loss limits, marking to market, etc.
1.3.6 Reinvestment Risk
Uncertainty with regard to interest rate at which the future cash flows could be reinvested is called
reinvestment risk. Any mismatches in cash flows would expose the banks to variations in NII as
the market interest rates move in different directions.
1.3.7 Net Interest Position Risk
The size of non-paying liabilities is one of the significant factors contributing towards profitability of
banks. Where banks have more earning assets than paying liabilities, interest rate risk arises when
the market interest rates adjust downwards. Thus, banks with positive net interest positions will
experience a reduction in NII as the market interest rate declines and increases when interest rate
rises. Thus, large float is a natural hedge against the variations in interest rates.
1.4 Measuring Interest Rate Risk
Before interest rate risk could be managed, they should be identified and quantified. Unless the
quantum of IRR inherent in the balance sheet is identified, it is impossible to measure the degree
of risks to which banks are exposed. It is also equally impossible to develop effective risk
management strategies/hedging techniques without being able to understand the correct risk
position of banks.
The IRR measurement system should address all material sources of interest rate risk including
gap or mismatch, basis, embedded option, yield curve, price, reinvestment and net interest
position risks exposures. The IRR measurement system should also take into account the specific
characteristics of each individual interest rate sensitive position and should capture in detail the
full range of potential movements in interest rates.
There are different techniques for measurement of interest rate risk, ranging from the traditional
Maturity Gap Analysis (to measure the interest rate sensitivity of earnings), Duration (to me asure
interest rate sensitivity of capital), Simulation and Value at Risk.
While these methods highlight different facets of interest rate risk, many banks use them in
combination, or use hybrid methods that combine features of all the techniques. Generally, the
approach towards measurement and hedging of IRR varies with the segmentation of the balance
sheet. In a well-functioning risk management system, banks broadly position their balance sheet
into Trading and Investment or Banking Books. While the assets in the trading book are held
primarily for generating profit on short-term differences in prices/yields, the banking book
comprises assets and liabilities, which are contracted basically on account of relationship or for
steady income and statutory obligations and are generally held till maturity. Thus, while the price
risk is the prime concern of banks in trading book, the earnings or economic value changes are the
main focus of banking book.
2. HEDGING INTEREST RATE RISK

Methods of Hedging of Interest Rate Risk can be broadly divided into following two categories:
(A) Traditional Methods: These methods can further be classified in following categories:
i. Asset and Liability Management (ALM)
ii. Forward Rate Agreement (FRA)
(B) Modern Methods: These methods can further be classified in following categories:
i. Interest Rate Futures (IRF)
ii. Interest Rate Options (IRO)
iii. Interest Rate Swaps
2.1 Traditional Methods
Now let us discuss some of the traditional methods of hedging interest rate ri sk.
2.1.1 Asset and Liability Management (ALM)
Asset-Liability Management (ALM) is one of the important tools of risk management in commercial
banks of India. Indian banking industry is exposed to a number of risks prevailing in the market
such as market risk, financial risk, interest rate risk etc. The net income of the banks is very
sensitive to these factors or risks. For this purpose, Reserve bank of India (RBI), regulator of
Indian banking industry evolved the tool known as ALM.
ALM is a comprehensive and dynamic framework for measuring, monitoring and managing the
market risk of a bank. It is the management of structure of Balance Sheet (liabilities and assets) in
such a way that the net earnings from interest are maximized within the overall risk preference
(present and future) of the institutions. The ALM functions extend to liquidly risk management,
management of market risk, trading risk management, funding and capital planning and profit
planning and growth projection.
The concept of ALM is of recent origin in India. It has been introduced in Indian Banking industry
w.e.f. 1st April, 1999. ALM is concerned with risk management and provides a comprehensive and
dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign
exchange and equity and commodity price risks of a bank that needs to be closely integrated with
the bank’s business strategy. Asset-liability management basically refers to the process by which
an institution manages its balance sheet in order to allow for alternative interest rate and liquidity
scenarios.
Banks and other financial institutions provide services which expose them to various kinds of risks
like credit risk, interest risk, and liquidity risk. Asset liability management is an approach that
provides institutions with protection that makes such risk acceptable. Asset -liability management
models enable institutions to measure and monitor risk, and provide suitable strategies for their
management.
It is therefore appropriate for institutions (banks, finance companies, leasing companies,
insurance companies, and others) to focus on asset-liability management when they face financial
risks of different types. Asset-liability management includes not only a formalization of this
understanding, but also a way to quantify and manage these risks. Further, even in the absence of
a formal asset-liability management program, the understanding of these concepts is of value to an
institution as it provides a true picture of the risk/reward trade-off in which the institution is
engaged.
Asset-liability management is a first step in the long-term strategic planning process.
Therefore, it can be considered as a planning function for an intermediate term. In a sense, the
various aspects of balance sheet management deal with planning as well as direction and control
of the levels, changes and mixes of assets, liabilities, and capital.
A sound investment decision depends on the correct use and evaluation of the rate of return.
Some of the different concepts of return are given as below:
2.1.2 Forward Rate Agreements (FRAs)
A Forward Rate Agreement (FRA) is an agreement between two parties through which a borrower/
lender protects itself from the unfavourable changes to the interest rate. Unlike futures FRAs are
not traded on an exchange thus are called OTC product. Following are main features of FRA.
• Normally it is used by banks to fix interest costs on anticipated future deposits or interest
revenues on variable-rate loans indexed to Benchmark Interest Rate e.g. LIBOR, MIBOR
etc.
• It is an off-Balance Sheet instrument.
• It does not involve any transfer of principal. The principal amount of the agreement is
termed "notional" because, while it determines the amount of the payment, actual exchange
of the principal never takes place.
• It is settled at maturity in cash representing the profit or loss. A bank that sells an FRA
agrees to pay the buyer the increased interest cost on some "notional" principal amount if
Reference Rate of some specified maturity is above a stipulated "Forward Interest Rate" on
the contract maturity or settlement date. Conversely, the buyer agrees to pay the seller any
decrease in interest cost if Reference Rate fall below the forward rate.
• Final settlement of the amounts owed by the parties to an FRA is determined by the formula
(N)(RR - FR)(dtm/DY)
Payment = 100
[1 + RR(dtm/DY)]
Where,
N= the notional principal amount of the agreement;
RR = Reference Rate for the maturity specified by the contract prevailing on the
contract settlement date; typically LIBOR or MIBOR
FR = Agreed-upon Forward Rate; and
dtm = maturity of the forward rate, specified in days (FRA Days)
DY = Day count basis applicable to money market transactions which could be 360 or 365
days.
If Reference Rate > FR the seller owes the payment to the buyer, and if Reference Rate <
FR the buyer owes the seller the absolute value of the payment amount determined by the
above formula.
• The differential amount is discounted at post change (actual) interest rate as it is settled in
the beginning of the period not at the end.
Example
Suppose two banks enter into an agreement specifying:
• a forward rate of 5 percent on a Eurodollar deposit with a three-month maturity;
• a $1 million notional principal; and settlement in one month.
Such an agreement is termed a 1x4 FRA because it fixes the interest rate for a deposit to be
placed after one month and maturing four months after the date the contract is negotiated.
If the three-month LIBOR is 6 percent on the contract settlement date, the seller would owe the
buyer the difference between 6 and 5 percent interest on $1 million for a period of 90 days.
Every 1 basis point change in the interest rate payable on a principal of $1 million for a 90 -day
maturity changes interest cost by $25, so that the increase in the interest cost on a three-month
Eurodollar deposit over the specified forward rate in this case is $25 x 100 basis points = $2,500.
The $2,500 difference in interest costs calculated above is discounted back three months using the
actual three-month LIBOR prevailing on the settlement date.
Thus, if 90-day LIBOR turns out to be 6 percent on the contract maturity date the buyer would
receive $2,463.05 = $2,500/[1 + 0.06(90/360)].
2.2 Modern Methods
Now let us discuss some of the modern methods of hedging interest rate risk.
2.2.1 Interest Rate Futures
As per Investopedia, an interest rate future is a futures contract with an underlying instrument that
pays interest. An interest rate future is a contract between the buyer and seller agreeing to the
future delivery of any interest-bearing asset. The interest rate future allows the buyer and seller to
lock in the price of the interest-bearing asset for a future date.
Interest rate futures are used to hedge against the risk that interest rates will move in an adverse
direction, causing a cost to the company.
For example, borrowers face the risk of interest rates rising. Futures use the inverse relationship
between interest rates and bond prices to hedge against the risk of rising interest rates.
A borrower will enter to sell a future today. Then if interest rates rise in the future, the value of the
future will fall (as it is linked to the underlying asset, bond prices), and hence a profit can be made
when closing out of the future (i.e. buying the future).
Currently, Interest Rate Futures segment of NSE offers two instruments i.e. Futures on 6 year, 10
year and 13 year Government of India Security and 91-day Government of India Treasury Bill
(91DTB).
Bonds form the underlying instruments, not the interest rate. Further, IRF, settlement is done at
two levels:
• Mark-to-Market settlement done on a daily basis and
• physical delivery which happens on any day in the expiry month.
Final settlement can happen only on the expiry date. Price of IRF determined by demand and
supply Interest rates are inversely related to prices of underlying bonds. In IRF following are two
important terms:
(a) Conversion factor: All the deliverable bonds have different maturities and coupon rates.
To make them comparable to each other, and also with the notional bond, RBI introduced
Conversion Factor. Conversion factor for each deliverable bond and for each expiry at the time of
introduction of the contract is being published by NSE.
(Conversion Factor) x (futures price) = actual delivery price for a given deliverable bond.
(b) Cheapest to Deliver (CTD): The CTD is the bond that minimizes difference between the
quoted Spot Price of bond and the Futures Settlement Price (adjusted by the conversion factor). It
is called CTD bond because it is the least expensive bond in the basket of deliverable bonds.
CTD bond is determined by the difference between cost of acquiring the bonds for delivery and the
price received by delivering the acquired bond. This difference gives the profit / loss of t he seller of
the futures.
Profit of seller of futures = (Futures Settlement Price x Conversion factor) – Quoted Spot Price of
Deliverable Bond
Loss of Seller of futures = Quoted Spot Price of deliverable bond – (Futures Settlement Price x
Conversion factor)
That bond is chosen as CTD bond which either maximizes the profit or minimizes the loss.
2.2.2 Interest Rate Options
Also known as Interest Rate Guarantee (IRG) as option is a right not an obligation and acts as
insurance by allowing businesses to protect themselves against adverse interest rate movements
while allowing them to benefit from favourable movements.
It should be noted that the IRO is basically a series of FRAs which are exercisable at
predetermined bench marked interest rates on each period say 3 months, 6 months etc. Some of
the important types of Interest Rate Options are as follows:
2.2.2.1 Cap Option
Also called Call Option, the buyer of an interest rate cap pays the seller a premium in return for the
right to receive the difference in the interest cost on some notional principal amount any time a
specified index of market interest rates rises above a stipulated "Cap Rate." The buyer bears no
obligation or liability if interest rates fall below the cap rate. Thus, a cap resembles an option in
that it represents a right rather than an obligation to the buyer.
Caps evolved from interest rate guarantees that fixed a maximum level of interest payable on
floating-rate loans. The advent of trading in over-the-counter interest rate caps dates back to 1985,
when banks began to strip such guarantees from floating-rate notes to sell to the market. The
leveraged buyout boom of the 1980s spurred the evolution of the market for interest rate caps.
Firms engaged in leveraged buyouts typically took on large quantities of short-term debt, which
made them vulnerable to financial distress in the event of a rise in interest rates. As a result,
lenders began requiring such borrowers to buy interest-rate caps to reduce the risk of financial
distress. More recently, trading activity in interest rate caps has declined as the number of new
leveraged buyouts has fallen. An interest rate cap is characterized by:
❖ a notional principal amount upon which interest payments are based;
❖ an interest rate benchmark say LIBOR, MIBOR, PLR etc. for typically some specified
maturity period;
❖ a cap rate, which is equivalent to a strike or exercise price of an option; and
❖ the period of the agreement, including payment dates and interest rate reset dates.
Payment schedules for interest rate caps follow conventions in the interest rate swap market.
Payment amounts are determined by the value of the benchmark rate on a series of interest rate
reset dates. Intervals between interest rate reset dates and scheduled payment d ates typically
coincide with the term of the benchmark interest rate.
If the specified market index is above the cap rate, the seller pays the buyer the difference in
interest cost on the next payment date. The amount of the payment is determined by the f ormula
(N) max (0, r - rc)(dt/No. of days a year),
where
N is the notional principal amount of the agreement,
r is the actual spot rate on the reset date
rc is the cap rate (expressed as a decimal), and
dt is the number of days from the interest rate reset date to the payment date.
Example
Consider a one-year interest rate cap that specifies a notional principal amount of $1 million and a
six-month LIBOR cap rate of 5 percent. Assume the agreement covers a period starting January
15 through the following January 15 with the interest rate to be reset on July 15. The first period of
a cap agreement typically is excluded from the agreement as it is known on the date of agreement.
Hence, the cap buyer will be entitled to a payment only if the six-month LIBOR exceeds 5 percent
on the July 15 interest rate reset date. Suppose that six-month LIBOR is 5.5 percent on July 15.
Then, on the following January 15 (184 days after the July 15 reset date) the seller will owe the
buyer.
$2,555.56 = ($1,000,000)(0.055 - 0.050)(184/360).
2.2.2.2 Floor Option

It is an OTC instrument that protects the buyer of the floor from losses arising from a decrease in
interest rates. The seller of the floor compensates the buyer with a pay off when the interest rate
falls below the strike rate of the floor.
If the benchmark rate is below the floor rate on the interest rate reset date the buyer receives a
payment of, which is equivalent to the payoff from selling an FRA at a forward rate. On the other
hand, if the index rate is above the floor rate the buyer receives no payment and loses the
premium paid to the seller. Thus, a floor effectively gives the buyer the right, but not the obligation,
to sell an FRA, which makes it equivalent to a European put option on an FRA. More generall y, a
multi-period floor can be viewed as a bundle of European-style put options on a sequence of FRAs
maturing on a succession of future maturity dates.
The payment received by the buyer of an interest rate floor is determined by the formula
(N) max(0, rf - r)(dt/No. of days a year),
Where,
rf is the floor rate or strike price, and
dt is the number of days from the last interest rate reset date to the payment date.
2.2.2.3 Interest Rate Collars
It is a combination of a Cap and Floor. The purchaser of a Collar buys a Cap and simultaneously
sells a Floor. A Collar has the effect of locking its purchases into a floating rate of interest that is
bounded on both high side and the low side.
Although buying a collar limits a borrower's ability to benefit from a significant decline in market
interest rates, it has the advantage of being less expensive than buying a cap alone because the
borrower earns premium income from the sale of the floor that offsets the cost of the cap. A zero-
cost collar results when the premium earned by selling a floor exactly offsets the cap premium.
The amount of the payment due to or owed by a buyer of an interest rate collar is determine d by
the expression
(N) [max(0, r - rc) - max(0, rf- r)](dt /No. of days a year),
Where,
rc is the cap rate,
rf is the floor rate, and

dt is the term of the index in days.
2.2.3 Interest Rate Swaps
In an interest rate swap, the parties to the agreement, termed the swap counterparties, agree to
exchange payments indexed to two different interest rates. Total payments are determined by the
specified notional principal amount of the swap, which is never actually exchanged.
2.2.3.1 Swap Dealers
The intermediary collected a brokerage fee as compensation, but did not maintain a continuing
role once the transaction was completed. The contract was between the two ultimate swap users,
who exchanged payments directly.
2.2.3.2 A fixed/floating swap is characterized by
❖ a fixed interest rate;
❖ a variable or floating interest rate which is periodically reset;
❖ a notional principal amount upon which total interest payments are based; and
❖ the term of the agreement, including a schedule of interest rate reset dates (that is, dates
when the value of the interest rate used to determine floating-rate payments is determined)
and payment dates.
2.2.3.3 Timing of Payments
A swap is negotiated on its "trade date" and settlement takes effect two days later called
"settlement date."
2.2.3.4 Price Quotation
The convention in the swap market is to quote the fixed interest rate as an All -In-Cost (AIC), which
means that the fixed interest rate is quoted relative to a flat floating-rate index.
2.2.3.5 Types of Swap
(a) Plain Vanilla Swap : Also called Generic Swap or Coupon Swap and it involves the
exchange of a fixed rate loan to a floating rate loan over a period of time and that too on notional
principal. Floating rate basis can be LIBOR, MIBOR, Prime Lending Rate etc.
For example, Fixed interest payments on a generic swap are calculated assuming each month has
30 days and the quoted interest rate is based on a 360-day year. Given an All-In-Cost of the swap,
the semiannual fixed-rate payment would be:
(N)(AIC)(180/360),
Where,
N denotes the notional principal amount of the agreement.
AIC denotes the fixed rate
Then, the floating-rate receipt is determined by the formula:
(N)(R)(dt/360)
Where,
dt denote the number of days since the last settlement date
R denotes the reference rate such as LIBOR, MIBOR etc.
(b) Basis Rate Swap: Also, called Non-Generic Swap. Similar to plain vanilla swap with the
difference that payments is based on the difference between two different variable rates. For
example one rate may be 1 month LIBOR and other may be 3-month LIBOR. In other words two
legs of swap are floating but measured against different benchmarks.
(c) Asset Swap: Like plain vanilla swaps with the difference that it is the exchange fixed rate
investments such as bonds which pay a guaranteed coupon rate with floating rate investments
such as an index.
(d) Amortising Swap: An interest rate swap in which the notional principal for the interest
payments declines during the life of the swap. They are particularly useful for borrowers who have
issued redeemable bonds or debentures. It enables them to interest rate hedging with redemption
profile of bonds or debentures.
2.2.4 Swaptions
An interest rate swaption is simply an option on an interest rate swap. It gives the holder the right
but not the obligation to enter into an interest rate swap at a specific date in the future, at a
particular fixed rate and for a specified term.
There are two types of swaption contracts: -
• A fixed rate payer swaption (also called Call Swaption) gives the owner of the swaption
the right but not the obligation to enter into a swap where they pay the fixed leg and receive
the floating leg.
• A fixed rate receiver swaption (also called Put Swaption) gives the owner of the swaption
the right but not the obligation to enter into a swap in which they will receive the fixed leg,
and pay the floating leg.
2.2.4.1 Principal Features of Swaptions
A. A swaption is effectively an option on a forward-start IRS, where exact terms such as the
fixed rate of interest, the floating reference interest rate and the tenor of the IRS are
established upon conclusion of the swaption contract.
B. A 3-month into 5-year swaption would therefore be seen as an option to enter into a 5-year
IRS, 3 months from now.
C. The 'option period' refers to the time which elapses between the transaction date and the
expiry date.
D. The swaption premium is expressed as basis points.
E. Swaptions can be cash-settled; therefore at expiry they are marked to market off the
applicable forward curve at that time and the difference is settled in cash.
2.2.4.2 Pricing of Swaptions
The pricing methodology depends upon setting up a model of probability distribution of the forwa rd
zero-coupon curve which undoes a Market process.
2.2.4.3 Uses of Swaptions
(a) Swaptions can be applied in a variety of ways for both active traders as well as for
corporate treasurers.
(b) Swap traders can use them for speculation purposes or to hedge a portion of their swap
books.
(c) Swaptions have become useful tools for hedging embedded optionality which is common to
the natural course of many businesses.
(d) Swaptions are useful to borrowers targeting an acceptable borrowing rate.
(e) Swaptions are also useful to those businesses tendering for contracts.
(f) Swaptions also provide protection on callable/puttable bond issues.
TEST YOUR KNOWLEDGE

1. Write a short note on Forward Rate Agreements.
2. What do you know about swaptions and their uses?
Practical Questions
1. M/s. Parker & Co. is contemplating to borrow an amount of `60 crores for a Period of 3
months in the coming 6 month's time from now. The current rate of interest is 9% p.a., but it
may go up in 6 month’s time. The company wants to hedge itself against the likely increase
in interest rate.
The Company's Bankers quoted an FRA (Forward Rate Agreement) at 9.30%p.a.
What will be the Final settlement amount, if the actual rate of interest after 6 months
happens to be (i) 9.60% p.a. and (ii) 8.80% p.a.?
2. TM Fincorp has bought a 6 x 9 ` 100 crore Forward Rate Agreement (FRA) at 5.25%. On
fixing date reference rate i.e. MIBOR turns out be as follows:
Period Rate (%)

3 months 5.50
6 months 5.70
9 months 5.85
(a) Profit/Loss to TM Fincorp. in terms of basis points.
(b) The settlement amount.
(Assume 360 days in a year)
3. XYZ Limited borrows £ 15 Million of six months LIBOR + 10.00% for a period of 24
months. The company anticipates a rise in LIBOR, hence it proposes to buy a Cap Option
from its Bankers at the strike rate of 8.00%. The lump sum premium is 1.00% for the
entire reset periods and the fixed rate of interest is 7.00% per annum. The actual
position of LIBOR during the forthcoming reset period is as under:
Reset Period LIBOR
1 9.00%
2 9.50%
3 10.00%
You are required to show how far interest rate risk is hedged through Cap Option.
For calculation, work out figures at each stage up to four decimal points and amount
nearest to £. It should be part of working notes.
4. Suppose a dealer quotes ‘All-in-cost’ for a generic swap at 8% against six month LIBOR
flat. If the notional principal amount of swap is ` 5,00,000.
(i) Calculate semi-annual fixed payment.
(ii) Find the first floating rate payment for (i) above if the six month period from the
effective date of swap to the settlement date comprises 181 days and that the
corresponding LIBOR was 6% on the effective date of swap.
In (ii) above, if the settlement is on ‘Net’ basis, how much the fixed rate payer would pay to
the floating rate payer?
Generic swap is based on 30/360 days basis.
5. Derivative Bank entered into a plain vanilla swap through on OIS (Overnight Index Swap)
on a principal of ` 10 crores and agreed to receive MIBOR overnight floating rate for a fixed
payment on the principal. The swap was entered into on Monday, 2 nd August, 2010 and was
to commence on 3rd August, 2010 and run for a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were:
7.75%,8.15%,8.12%,7.95%,7.98%,8.15%.
If Derivative Bank received ` 317 net on settlement, calculate Fixed rate and interest under
both legs.
Notes:
(i) Sunday is Holiday.
(ii) Work in rounded rupees and avoid decimal working.
6. A Inc. and B Inc. intend to borrow $200,000 and $200,000 in ¥ respectively for a time
horizon of one year. The prevalent interest rates are as follows:
Company ¥ Loan $ Loan
A Inc 5% 9%
B Inc 8% 10%
The prevalent exchange rate is $1 = ¥120.
They entered in a currency swap under which it is agreed that B Inc will pay A Inc @ 1%
over the ¥ Loan interest rate which the later will have to pay as a result of the agreed
currency swap whereas A Inc will reimburse interest to B Inc only to the extent of 9%.
Keeping the exchange rate invariant, quantify the opportunity gain or loss component of the
ultimate outcome, resulting from the designed currency swap.
7. A textile manufacturer has taken floating interest rate loan of ` 40,00,000 on 1 st April, 2012.
The rate of interest at the inception of loan is 8.5% p.a. interest is to be paid every year on
31st March, and the duration of loan is four years. In the month of October 2012, the Central
bank of the country releases following projections about the interest rates likely to prevail in
future.
(i) On 31st March, 2013, at 8.75%; on 31 st March, 2014 at 10% on 31 st March, 2015 at
10.5% and on 31 st March, 2016 at 7.75%. Show how this borrowing can hedge the
risk arising out of expected rise in the rate of interest when he wants to peg his
interest cost at 8.50% p.a.
(ii) Assume that the premium negotiated by both the parties is 0.75% to be paid on 1 st
October, 2012 and the actual rate of interest on the respective due dates happens to
be as: on 31st March, 2013 at 10.2%; on 31 st March, 2014 at 11.5%; on 31st March,
2015 at 9.25%; on 31 st March, 2016 at 9.0% and 8.25%. Show how the settlement
will be executed on the perspective interest due dates.
ANSWERS/ SOLUTIONS
1. Final settlement amount shall be computed by using formula:
(N)(RR - FR)(dtm/DY)
=
[1 + RR(dtm/DY)]
Where,
N= the notional principal amount of the agreement;
RR = Reference Rate for the maturity specified by the contract prevailing on the
contract settlement date;
FR = Agreed-upon Forward Rate; and
dtm = maturity of the forward rate, specified in days (FRA Days)
DY = Day count basis applicable to money market transactions which could be 360
or 365 days.
Accordingly,
If actual rate of interest after 6 months happens to be 9.60%
(` 60crore)(0.096- 0.093)(3/12)
=
[1 + 0.096(3/12)]
(` 60crore)(0.00075)
= = ` 4,39,453
1.024
Thus banker will pay Parker & Co. a sum of ` 4,39,453
If actual rate of interest after 6 months happens to be 8.80%
(` 60crore)(0.088- 0.093)(3/12)
=
[1 + 0.088(3/12)]
(` 60crore)(-0.00125)
= = - ` 7,33,855
1.022
Thus Parker & Co. will pay banker a sum of ` 7,33,855

Note: It might be possible that students may solve the question on basis of days ins tead of
months (as considered in above calculations). Further there may be also possibility that the
FRA days and Day Count convention may be taken in various plausible combinations such
as 90 days/360 days, 90 days/ 365 days, 91 days/360 days or 91 days/3 65days.
2. (a) TM will make a profit of 25 basis points since a 6X9 FRA is a contract on 3-month
interest rate in 6 months, which turns out to be 5.50% (higher than FRA price).
(b) The settlement amount shall be calculated by using the following formula:
N(RR - FR)(dtm / 360)
1+ RR(dtm / 360)
Where
N = Notional Principal Amount
RR = Reference Rate
FR = Agreed upon Forward Rate
Dtm = FRA period specified in days.
Accordingly:
100crore (5.50% - 5.25%)(92*/360)
= ` 6,30,032
1 + 0.055(92*/360)
Hence there is profit of ` 6,30,032 to TM Fincorp.

* Alternatively, it can also be taken as 90 days.
3. First of all we shall calculate premium payable to bank as follows:
rp rp
P= X A or A
 1  PVAF(3.5% ,4)
(1  i) - 
 i  (1 + i)t 
Where
P = Premium
A = Principal Amount
rp = Rate of Premium
i = Fixed Rate of Interest
t = Time
0.01 0.01
= × £15,000,000 or
 1  (0.966 + 0.933 + 0.901+ 0.871)
(1/ 0.035) - 0.035  1.0354 
× £15,000,000
0.01 £150,000
= × £15,000,000 or = £ 40,861
 1  3.671
(28.5714) - 0.04016 
Please note above solution has been worked out on the basis of four decimal points at each
stage.
Now we see the net payment received from bank
Reset Additional Amount Premium paid Net Amt.

Period interest due to received from to bank received from
rise in interest bank bank
rate
1 £ 75,000 £ 75,000 £ 40,861 £34,139
2 £ 112,500 £ 112,500 £ 40,861 £71,639
3 £ 150,000 £ 150,000 £ 40,861 £109,139
TOTAL £ 337,500 £ 337,500 £122,583 £ 214,917
Thus, from above it can be seen that interest rate risk amount of £ 337,500 reduced by
£ 214,917 by using of Cap option.
Note: It may be possible that student may compute upto three decimal points or may use
different basis. In such case their answer is likely to be different.
4. (i) Semi-annual fixed payment
= (N) (AIC) (Period)
Where N = Notional Principal amount = `5,00,000
AIC = All-in-cost = 8% = 0.08
 180 
= 5,00,000 × 0.08  
 360 
= 5,00,000 × 0.08 (0.5)
= 5,00,000 × 0.04 = `20,000/-
(ii) Floating Rate Payment

 dt 
= N (LIBOR)  
 360 
181
= 5,00,000 × 0.06 ×
360
= 5,00,000 × 0.06 (0.503) or 5,00,000 × 0.06 (0.502777)
= 5,00,000 × 0.03018 or 0.30166 = `15,090 or 15,083
Both are correct
(iii) Net Amount
= (i) – (ii)
= `20,000 – `15,090 = `4,910
or = `20,000 – `15,083 = `4,917
5.
Day Principal (`) MIBOR (%) Interest (`)
Tuesday 10,00,00,000 7.75 21,233
Wednesday 10,00,21,233 8.15 22,334
Thursday 10,00,43,567 8.12 22,256
Friday 10,00,65,823 7.95 21,795
Saturday & Sunday (*) 10,00,87,618 7.98 43,764
Monday 10,01,31,382 8.15 22,358
Total Interest @ Floating 1,53,740
Less: Net Received 317
Expected Interest @ fixed 1,53,423
Thus Fixed Rate of Interest 0.07999914
Approx. 8%
(*) i.e. interest for two days.
Note: Alternatively, answer can also be calculated on the basis of 360 days in a year.
6.
Opportunity gain of A Inc under currency Receipt Payment Net
swap
Interest to be remitted to B. Inc in
$ 2,00,000х9%=$18,000 ¥21,60,000
Converted into ($18,000х¥120)
Interest to be received from B. Inc in $ ¥14,40,000 -
converted into Y (6%х$2,00,000 х ¥120)
Interest payable on Y loan - ¥12,00,000
¥14,40,000 ¥33,60,000
Net Payment ¥19,20,000 -
¥33,60,000 ¥33,60,000
$ equivalent paid ¥19,20,000 х(1/¥120) $16,000
Interest payable without swap in $ $18,000
Opportunity gain in $ $ 2,000
Opportunity gain of B inc under currency swap Receipt Payment Net

Interest to be remitted to A. Inc in ($ 2,00,000 х $12,000
6%)
Interest to be received from A. Inc in Y $18,000
converted into $ =¥21,60,000/¥120
Interest payable on $ loan@10% - $20,000
$18,000 $32,000
Net Payment $14,000 -
$32,000 $32,000
Y equivalent paid $14,000 X ¥120 ¥16,80,000
Interest payable without swap in ¥ ¥19,20,000
($2,00,000X¥120X8%)
Opportunity gain in Y ¥ 2,40,000
Alternative Solution
Cash Flows of A Inc
(i) At the time of exchange of principal amount
Transactions Cash Flows
Borrowings $2,00,000 x ¥120 + ¥240,00,000
Swap - ¥240,00,000
Swap +$2,00,000
Net Amount +$2,00,000
(ii) At the time of exchange of interest amount

Interest to the lender ¥240,00,000X5% ¥12,00,000
Interest Receipt from B Inc. ¥2,00,000X120X6% ¥14,40,000
Net Saving (in $) ¥2,40,000/¥120 $2,000
Interest to B Inc. $2,00,000X9% -$18,000
Net Interest Cost -$16,000
A Inc. used $2,00,000 at the net cost of borrowing of $16,000 i.e. 8%. If it had not
opted for swap agreement the borrowing cost would have been 9%. Thus there is
saving of 1%.
Cash Flows of B Inc
(i) At the time of exchange of principal amount
Borrowings + $2,00,000
Swap - $2,00,000
Swap $2,00,000X¥120 +¥240,00,000
Net Amount +¥240,00,000
(ii) At the time of exchange of interest amount

Interest to the lender $2,00,000X10% - $20,000
Interest Receipt from A Inc. +$18,000
Net Saving (in ¥) -$2,000X¥120 - ¥2,40,000
Interest to A Inc. $2,00,000X6%X¥120 - ¥14,40,000
Net Interest Cost - ¥16,80,000
B Inc. used ¥240,00,000 at the net cost of borrowing of ¥16,80,000 i.e. 7%. If it had
not opted for swap agreement the borrowing cost would have been 8%. Thus there is
saving of 1%.
7. As borrower does not want to pay more than 8.5% p.a., on this loan where the rate of
interest is likely to rise beyond this, hence, he has hedge the risk by entering into an
agreement to buy interest rate caps with the following parameters:
• National Principal: ` 40,00,000/-
• Strike rate: 8.5% p.a.
• Reference rate: the rate of interest applicable to this loan
• Calculation and settlement date: 31 st March every year
• Duration of the caps: till 31st March 2016
• Premium for caps: negotiable between both the parties
To purchase the caps this borrower is required to pay the premium upfront at the time of
buying caps. The payment of such premium will entitle him with right to receive the
compensation from the seller of the caps as soon as the rate of interest on this loan rises
above 8.5%. The compensation will be at the rate of the difference between the rate of none
of the cases the cost of this loan will rise above 8.5% calculated on ` 40,00,000/-. This
implies that in none of the cases the cost of this loan will rise above 8.5%. This hedging
benefit is received at the respective interest due dates at the cost of premium to be paid
only once.
The premium to be paid on 1 st October 2012 is 30,000/- (` 40,00,000 x 0.75/100). The
payment of this premium will entitle the buyer of the caps to receive the compensation from
the seller of the caps whereas the buyer will not have obligation. The compensation
received by the buyer of caps will be as follows:
On 31st March 2013
The buyer of the caps will receive the compensation at the rate of 1.70% (10.20 - 8.50) to
be calculated on ` 40,00,000, the amount of compensation will be ` 68000/- (40,00,000 x
1.70/100).
On 31st March 2014
The buyer of the caps will receive the compensation at the rate of 3.00% (11.50 – 8.50) to
be calculated on ` 40,00,000/-, the amount of compensation will be ` 120000/- (40,00,000 x
3.00/100).
On 31st March 2015

The buyer of the caps will receive the compensation at the rate of 0.75% (9.25 – 8.50) to be
calculated on ` 40,00,000/-, the amount of compensation will be ` 30,000 (40,00,000 x
0.75/100).
On 31st March 2016
The buyer of the caps will not receive the compensation as the actual rate of interest is 8.25%
whereas strike rate of caps is 8.5%. Hence, his interest liability shall not exceed 8.50%.
Thus, by paying the premium upfront buyer of the caps gets the compensation on the
respective interest due dates without any obligations.
12
CORPORATE VALUATION
LEARNING OUTCOMES
❑ Conceptual Framework of Valuation
❑ Approaches/ Methods of Valuation
(a) Assets Based Valuation Model
(b) Earning Based Models
(c) Cash Flow Based Models
❑ Measuring Cost of Equity
- Capital Asset Pricing Model (CAPM)
- Arbitrage Pricing Theory
- Estimating Beta and Valuation of Unlisted Companies
❑ Relative Valuation
❑ Other Approaches to Value Measurement
- Contemporary Approaches to Valuation
- Chop Shop Method
- Economic Value Added (EVA)
- Market Value Added (MVA)
- Shareholder Value Analysis (SVA)
❑ Arriving at Fair Value
1. CONCEPTUAL FRAMEWORK OF VALUATION

The syllabus of this paper requires you to have expert knowledge of various techniques of
valuation of various securities (e.g. equity shares, preference shares and bonds etc.) as well as of
business. While the topic of Valuation of Securities we discussed earlier now we shall discuss the
topic of ‘Valuation of Business’ that too in corporate context. Though Corporate Valuation can be
carried out for various purpose but here we shall mainly using the same for the Mergers and
Acquisitions decisions, the next topic for the discussion.
The basic purpose of any enterprise is to earn profits in order to sustain itself and promote growth.
Managements across the world endeavor in this aspect – be it be a sole proprietorship concern or
a multinational giant having its foothold across geographies.
Corporate valuation can be traced back to centuries ago when the United East India Company
(referred to as ‘Dutch East India Company’ by the Britishers) was the first corporation to be valued
and an IPO was launched. The East India Company too stands as a fine example of a corporatized
way of doing world trade, and perhaps the earliest of institutions to focus on wealth maximization,
albeit in unethical ways. Today, almost every enterprise that generates a positive cash flow and
generates suitable employment opportunities feels the pressing need to ‘value’ itself – be it for
going to the local bank for debt financing, or for assessing an initial public offering.
It is obvious that the more an enterprise grows, the more the number of stakeholders it adds in its
progress to growth. Presentation of annual financial statements in the annual body meeting,
publishing quarterly results for the street – all these become the staple diet for stakeholders who
sow the seeds of capital in the enterprise and in turn, wait for the enterprise to multiply its
progressive potencies. In a relative world, this persisting curiosity of the stakeholders to
understand the ‘true worth’ of their enterprise becomes translated to the concept of ‘valuation’. Add
to it, the market analysts, financial intermediaries, and let’s not forget the academicians, and what
we have is a handful of valuation approaches that have been painstakingly and meticulously
crafted for valuing the correct worth of the enterprise at hand. In a true sense, valuation imbibes
both the science and the art of itself per se. As it stands today, valuation has become an
inseparable part of strategic financial management.
To elaborate, the need of a proper assessment of an enterprise’s value can be typically for:
(a) Information for its internal stakeholders,
(b) Comparison with similar enterprises for understanding management efficiency,
(c) Future public listing of the enterprise,
(d) Strategic planning, for e.g. finding out the value driver of the enterprise, or for a correct
deployment of surplus cash,
(e) Ball park price (i.e. an approximate price) for acquisition, etc.
CORPORATE VALUATION 712.3
2. IMPORTANT TERMS ASSOCIATED WITH VALUATION

It’s imperative to understand the important terms that we would come across and will be used
widely in any valuation model. Some of the terms have indeed evolved over a period of time and
continued usage, and now stand on their own as precursor to application of the actual valuation
model itself.
2.1 The Concept of PV (Present Value) of cash flows
Needless to state that all student must have referred and understood thoroughly the concept of
‘Time Value of Money’ at Intermediate Level in the paper of Financial Management. Accordingly, a
receipt of ` 1,000 twelve months hence would not be the same as of today, because of concept of
Time Value of Money and the discounted value of ` 1,000 a year at the rate of 10% shall be ` 909
approximately.
2.2 The Concept of IRR (Internal Rate of Return)
Similar to above this concept has also been discussed in the paper of Strategic Financial
Management at Intermediate Level. IRR is the discount rate that will equate the present value
(NPV) of all cash flows from a particular investment or project to zero. We can also visualize IRR
as a discount rate that will get the PVs of cash inflows equal to the investment.
The Decision Rule – the higher the IRR of a project, the more likely it gets selected for further
investments.
2.3 ROI (Return on investment)
Simply put, ROI is the return over the investment made in an entity from a stakeholder point of
view.
A simple example would be where the stakeholder has sold shares valued at 1400, invested
initially at 1000; the ROI would be the return divided by the investment cost, which would be
(1400-1000)/1000 = 40% in this case. You would have noted that the 40% is the return on cash
investment for this standalone transaction, primarily signifying the absolute rate of return on
liquidating his holdings. But if the stakeholder sells his shares that was held by him from the past
several years, he would try to calculate the ROI by taking into account the time value of money.
This would imply that the ROI gets ‘adjusted’ over the period of his holdings. So, if a stakeholder
had worth 1000 of shares at the beginning of the year and he makes an additional investment of
200 during the year, and his investment is valued at 2000 at the end of the year, his ROI would be
calculated as returns divided by the average investment held during the year. His returns would be
(2000-1200 = 800) and the average investment would be [(1000+1200)/2] = 1100 for the year.
Accordingly, his ROI will be 800/1100 = 72%. The average cost of investments is arrived at to
recognize the timing of the investment. In this case, the stakeholder may also calculate the actual
days of the additional investment, to arrive at the exact ROI. However, stakeholders who are
multiple investments and portfolios will use the average cost of investments as illustrated above.
From an entity’s point of view, the most significant use of ROI would be to calculate the returns
generated by each individual / incremental investment on a project or different projects. Thus, a
company that has initiated a couple of projects during the year towards new business lines can
implement the ROI concept to calculate the returns on the investment and take further decisions
based on the same. Note that ROI is a historical ratio, so naturally the decision can either only be
a course corrective action, or channeling further investments into the more successful business
line.
By now you will appreciate that essentially, we are viewing ROI as a performance measure ratio in
the corporate scenario; which also brings us to an interesting question –how about measuring
returns against the total investments, or simply put, the total ‘assets’ held by the enterprise? After
all, it is imperative that all assets are put forth and only for the purpose of wealth maximization and
fullest returns, right? And that’s precisely the concepts seen below.
2.4 Perpetual Growth Rate (Gordon Model)
As discussed in the chapter of Cost of Capital at Intermediate Level the Gordon’s model assumes
a perpetual growth in dividend; thereby potential investor eyeing stable inflows will take the latest
Dividend payout and factor it with his expected rate of return.
This model is not widely used by potential investors because of following reasons:
(i) there are more parameters which need to be factored in, and
(ii) dividends rarely grow perpetually at a steady rate.
However, this model is the darling of academicians as it can neatly fit into a ‘constant rate’ model
for deliberation purposes.
2.5 The term ‘TV’ (Terminal Value)
Terminal’ refers to the ‘end’ of something – in the valuation world, to ‘terminate’ would be to exit
out of a particular investment or line of business. So, when an investor decides to pull out and
book profits, he would not only be expecting a fair value of the value created, but also would
definitely look to the ‘horizon’ and evaluate the future cash flows, to incorporate them into his
‘selling price’. Hence, Terminal Value (TV) is also referred to as the ‘Horizon Value’ that the
investor forecasts for valuing his investment at the exit point. Mostly TV is estimated using a
perpetual growth model as per the Gordon model. We will see the practical usage of TV in the
various questions/ illustrations during the study of this Paper.
3. APPROACHES/ METHODS OF VALUATION

As mentioned earlier one of the purpose of the valuation is Mergers and Acquisitions as the
carrying out valuation of target company becomes important to gauge out the price to be of fered to
it. The target company can be listed or unlisted. If the target company is unlisted then the price of
acquisition shall be at the negotiated price acceptable by both companies. For listed companies
stock market value or market capitalization can form the basis of valuation of target company.
Though stock market price is a guide to the acquiring company but it does not give an estimate
how much the target company is worth as stock price will also depend on Market Efficiency.
Further in some cases even small portion of total shares is quoted and hence market price
represents a marginal portion of overall capital. This calls for further analysis of valuation of target
company.
As mentioned earlier the valuation of securities especially valuation of equity shares has been
covered in chapter on Security Valuation in this chapter we shall focus on methods of valuation
other than discussed in the chapter on Security Valuation.
Broadly there are three approaches to value an enterprise:
(a) Assets Based Valuation Model
(b) Earning Based Models
(c) Cash Flow Based Models
In addition to the above there are some other methods. First let’s see above three methods in
detail as below:
3.1 Asset Based Approach
Being a straight forward method, the value of shares of target company is computed in terms of
net assets acquired. This method of valuation is not based on income generation rather than on
income generating assets.
This method is least important in case of IT companies where ‘hard’ assets make little im portance
as these companies’ assets are intellectual property rights and human resources.
This approach further can be classified into following three methods:
3.1.1 Net Asset Value
The most simplest method also called ‘Book Value’ Method computes the valu e of the shares of
the company as follows:
Net Fixed Asset = Fixed Assets + Net Current Assets – Long Term Debt
Though this method as advantage of being simplest as it uses historical costs which are easily
available but it has little relevance as Balance Sheet is not a valuation device. Therefore, this
method offers a loser limit to value the shares of target company.
Further this method ignores the current asset valuation even for intangible assets such as Brand,
Intellectual Property Rights etc.
3.1.2 Net Realizable Value

Also called Liquidation Value or Adjusted Book Value it can be defined as realizable value of all
assets after deduction of liquidation expenses and paying off liabilities. Though in some case
liquidation expenses can be ignored if business of target company is acquired as a going concern.
Despite appearing to be simple method the calculation of net realizable value may not be so
simple as being an off-market purchase it is likely that buyer may offer lowest prices.
This method is not so popular as it involves total break up of the target company. This method is
generally useful where the acquirer is interested in selling one part of business and integrate
remaining part of the business with the existing operations.
In the below example we see that the realizable values are different as compared to the book
values:
Book Values Net Realizable Values
Long Term Debt
(Term Loan from ZB Bank) 10,000 10,000
Current Liabilities 10,000 10,000
Total Liabilities (A) 20,000 20,000
Non-Current Assets (B)

PPE 50,000 40,000
30,000
Licenses 10,000 60,000 70,000
Current Assets (C)

Sundry Debtors 50,000 45,000
10,000
Cash 10,000 60,000 55,000
Net Assets (B) + (C) – (A) 1,00,000 1,05,000

Thus, total net realizable assets of the net book value of ` 1,00,000 in the above example would
` 105,000 and if there are 5000 equity shares then the value of per share will be ` 21.
3.1.3 Replaceable Value
This method involves valuation as per determination of the cost of group of assets and liabilities of
equivalent company in the open market. This method has advantage over Book Value as it takes
into consideration proper valuation and generally it is slightly higher than Net Realizable Va lue as
quick asset disposal is not encouraged. And due to this reason many author believes that it is the
maximum price that an acquirer would pay for the equivalent business. However, this approach
also suffers from limitation that hard assets are taken into consideration still loyalty of the staff
cannot be taken into consideration.
Conclusions: The asset-based approach can depict the enterprise’s net worth fairly correctly
using the fundamental principle of ‘going concern’. However, it suffers from a major drawback – It
fails to consider the ability of the enterprise to generate future revenues and how the market
dynamics will affect the future operations and cash flow.
3.2 Income based Approach
This approach looks to overcome the drawbacks of using the asset-backed valuation approach by
referring to the earning potential. This method is more suitable when acquiring company is
intending to continue business of target company for foreseen future without selling or liquidating
assets of the same. Accordingly, if there is any additional earning is there due to acquisition same
should also be considered in valuation. Basically, PE Ratio also called Earning Yield is used in this
approach. Though there is another version of the same is Capitalization Rate.
Now let us discuss valuation by these two versions one by one.
3.2.1 PE Ratio or Earning Yield Multiplier
This method is generally used for valuing listed companies whose PE Ratios are available. This
approach has one benefit that it takes into account the expected growth rate of the company as
well as market expectations.
The price or value of equity share can be calculated using the following equation:
Price Per Share = EPS x PE Ratio
Though mainly this method is followed for listed companies but PE Ratio of equivalent companies
or the industry can be used to value the shares of the unlisted companies. This method serves as
minimum acceptable price to the shareholders of the target company. It involves following steps:
(i) Choosing PE Ratio of equivalent quoted company.
(ii) Making adjustment downward for additional risk due to non listing of shares.
(iii) Determination of future maintainable EPS.
(iv) Multiply same EPS with adjusted PE Ratio.
3.2.2 Capitalisation of Earning
In this method the value of business is calculated by capitalization of company’s expected annual
maintainable profit using appropriate required rate of return or yield or discounting rate.
Annual expected maintainable profit can be calculated using weighted average of previous years’
profits after adjusting synergy benefits or economy of scales in the same profit.
The capitalization rate depends on many factors. The capitalization rate can be approximated as
follows:
EPS
Required Earning Yield =
SharePrice
Or
1
Reciprocal of PE Ratio =
PE Ratio
Using this method valuation of the company can be computed as follows:
Expected Annual Maintainable Profit
Capitalized Earning Value =
Capitalization Rate or Required Earning Yield
Though the main advantage of using this method is that it is forward looking approach howe ver the
disadvantages are estimation of expected future profit and difference in treatment of extra ordinary
and exceptional items.
3.3 Cash flow based approach
As opposed to the asset based and income based approaches, the cash flow approach takes into
account the quantum of free cash that is available in future periods, and discounting the same
appropriately to match to the flow’s risk. Variant of this approach in context of equity has been
discussed earlier in the chapter of Security Valuation.
Simply speaking, if the present value arrived post application of the discount rate is more than the
current cost of investment, the valuation of the enterprise is attractive to both stakeholders as well
as externally interested parties (like stock analysts). It attempts to overcome the problem of over-
reliance on historical data as seen in both the previous methods. There are essentially five steps in
performing DCF based valuation:
(a) Arriving at the ‘Free Cash Flows’
(b) Forecasting of future cash flows (also called projected future cash flows)
(c) Determining the discount rate based on the cost of capital
(d) Finding out the Terminal Value (TV) of the enterprise
(e) Finding out the present values of both the free cash flows and the TV, and interpretation of
the results.
Let’s take an example, with assumed figures, to understand how the DCF method works:
Step a:
INR ('000s)
Computation of free cash flows 2016-17 Remarks
EAT (Earning After Taxes) 600
One time events to be
Less: One time incomes (200) eliminated
One time events to be
Add: One time expenses 100 eliminated
Add: Depreciation 100 Depreciation is a book entry
Free Cash Flow 600
Step b:
Assumptions to arrive at Adjusted Free Cash Flow as below:
Free Cash Flow estimated to grow @ 5% p.a.
Suitable assumptions to be made for changes in WC and investments in FA
Projected (in INR '000s)
2017-18 2018-19 2019-20
Free Cash Flow (5 % increment Y-o-Y) 600.00 630.00 661.50
Less: Changes in Working Capital Cycle (50.00) (30.00) 10.00
Less: Investment in Fixed assets (50.00) (50.00) (20.00)
Adjusted Free Cash Flow 500.00 550.00 651.50
Step c:
Discounted Cash Flows (in INR '000s)
2017-18 2018-19 2019-20
WACC (assumed) 8% 8% 8%
PVF 0.926 0.857 0.794
Present Value of Cash flow 463.00 471.35 517.29
Step d:
Terminal Value: The perpetual growth that will be achieved after year 3 onwards is assumed @ 3%
Therefore, TV = (CF at Year 3 * growth rate) / (WACC - growth rate) = (517.29*1.03)/(0.08 - 0.03)
= 10656.17
Step e:
Total DCF of enterprise = 12,107.81 thousands (PV of cash flows arrived in above table plus the
TV arrived)
In other words, the value of the enterprise for a potential acquisition is approximately 12108
thousands.
The DCF is indeed a revolutionary model for valuation as FCFs truly represen t the intrinsic value
of an entity. However, the whole calculation gravitates heavily on the WACC and the TV. In fact in
many cases the TV is found to be a significant portion in final value arrived by DCF. This means
that the growth rate and underlying assumptions need to be thoroughly validated to deny any room
for margin of error of judgment.
4. MEASURING COST OF EQUITY

4.1 Capital Assets Pricing Model (CAPM)
An alternative way to look at value of an investment or a portfolio is to view returns as a direct
benefit of assuming risks. As discussed earlier the CAPM model is represented by the below
formula:
R = rf + β (rm- rf)
Where R = expected rate of return
rf = risk free rate of return
β = Beta value of the stock
Rm = market rate of return
4.2 Arbitrage Pricing Model
It is obvious that the CAPM has gained massive popularity due to its ‘intuitive based approach’ of
classifying risks into 2 buckets – ‘a risk free part’ and ‘the risk part that is relative to the market
index’. However, this is also its greatest inherent weakness - the oversimplification of risks.
In the 1970’s Mr. Stephen Alan Ross, professor and economist, introduced the concept of ‘multiple
factors’ that can influence the risk component – motley of ‘macro-economic factors’. So, the basic
idea is to breakdown risks into individual identifiable elements that influence the overall risk in a
proportion (called ‘factor’), and each factor gets assigned its own beta; and the sum total of all the
assets’ ‘sensitivities’ to ‘n’ factors will give the ‘expected rate of return for the asset’.
In a simplistic way, if a particular asset, say a stock, has its major influencers as the ‘interest rate
fluctuations’ and the ‘sectoral growth rate’, then the stocks’ return would be calculated by using the
Arbitrage Pricing Theory (APT) in the following manner:
(a) Calculate the risk premium for both these two risk factors (beta for the risk factor 1 –
interest rate, and beta of the risk factor 2 – sector growth rate; and,
(b) Adding the risk free rate of return.
Thus, the formula for APT is represented as –
Rf+ β1(RP1) + β2(RP2) + ….βj(RPn)
It is thereby clear that APT strives to model E(R) as ‘a linear function of various macro-economic
factors’ where sensitivity to changes in each factor is represented by a factor-specific beta
coefficient. Note that the APT by itself doesn’t provide for the macro-economic factors that will be
needed to be tested for its sensitivity – however these have to be judicially developed by the
financial analysts keeping in mind the economy they are put in.
4.3 Estimating Beta and Valuation of Unlisted Companies
You would have by this time realized the fact that ‘information’ holds the key to a successful
valuation of an enterprise. The above valuation approaches we have seen viz. asset based,
earnings based and cash flow based, can be applied freely for publicly traded companies where
key information as regards to earnings, assets employed, and board’s opinion on future potential
and growth areas are readily available. Already, audited financial statements are widely used by
financial analysts for various fund and brokerage houses to prepare their ‘review scorecards’ that
will help the investor to decide whether to hold or sell the scripts on the trade bourses.
However, in a developing economy like India, where there are many privately held firms into e-
retail, service management, hospitality, and such other sunrise sectors that are holding out a lot of
promise and are increasingly getting attention as ‘dark horse’ by venture capitalists, angel
investors etc.; the moot question is how to value these entities in the absence of publicly available
information? There are many a time that the directors of these companies do approach CAs for
getting a ‘valuation’ done. The qualified accountant in private companies will also be involved in
the valuation process. What needs to be appreciated is that valuation is indeed an onerous task,
but if meticulously approached, can yield many dividends.
The biggest challenge in calculation of the ‘value’ of a privately held enterprise is arriving at the
Cost of Capital which in turn depends on Beta for the private firm. We have to keep in mind that
most of the publicly listed companies have leveraged capital, whereas the privately owned firms
may not have either zero or insignificant amounts of debt. However, the strategic investor looking
for stake would always like to grow it further on leveraged funds going forward. In fact this is the
precisely the way forward – to raise funds thru corporate bonds and debt instruments but as on the
valuation date, the fact remains that the beta will have to reflect the ‘unleveraged’ posi tion, and
hence, we would use the ‘unlevered beta’, as opposed to levered beta.
Further this problem can also be faced in case of even an existing listed company whi ch decides
to invest in brand new line of business for it. In such situation company should not use its WACC
to evaluate this project. Instead of that it should assess the WACC for the appropriate risk level.
For this the company needs Asset Beta or Ungeared Beta, which needs to be adjusted according
to own gearing level. The Asset Beta represents only systematic risk of the underlying project or
asset of the company and it does not represents any financial risk.
In other words it can be said that Asset Beta represents only company’s business risk. Applying
similar logic of calculation of WACC, the Asset Beta of the company can be calculated using
following equation.
 E   D(1- t) 
βa =β e   + βd  
 E+ D(1- t)   E+ D(1- t) 
βa = Ungeared or Asset Beta
βe = Geared or Equity Beta
βd = Debt Beta
E = Equity
D = Debt
t = Tax Rate
From the above equation it can be seen that company’s Equity Beta shall always be greater than
Asset Beta. In case company is debt free then Equity Beta shall be equal to Asset Beta.
Generally it is assumed that the Debt Beta tends to be Zero as Bonds ’ Returns are not linked to
the volatility of market portfolio. In such situation the above mentioned equation shall become:
 E 
βa =β e  
 E+ D(1- t) 
Thus, if we have been provided with figures of βe of a company we can calculate β a, which shall be
common for the industry or Pure Play firm.
Now let us see what steps are exactly involved in computation of Equity Beta for a new of business
or project for the company.
Step 1: Identify the Pure Play firms or companies (engaged entirely in same business and also
called proxy companies) and their Equity Betas to surrogate the Equity Beta of new Project or
business.
Step 2: Once Beta of proxy companies have been identified we de-gear it and compute the Asset
Beta as the different companies may have different gearing levels.
Step 3: In case if there is only one proxy company then Asset Beta of the same company shall be
continued for further analysis. In case there are more than one proxy companies then we sha ll
take average of Asset Betas of these companies. Otherwise we can also opt for the Asset Beta of
the company that appears to be most appropriate.
Step 4: In next step we must re-gear the Asset Beta as per capital structure of the appraising
company to reflect the financial risk using the following formula (changing the positions of Asset
Beta mentioned earlier)
 E+ D(1- t) 
βe =β a  
 E 
Step 5: In this step we can insert computed βe in CAPM and can compute required rate of return
for project under consideration or value of the business.
Illustration 1
There is a privately held company X Pvt. Ltd that is operating into the retail space, and is now
scouting for angel investors. The details pertinent to valuing X Pvt. Ltd are as follows –
The company has achieved break even this year and has an EBITDA of 90. The unleveraged beta
based on the industry in which it operates is 1.8, and the average debt to equity ratio is hovering at
40:60. The rate of return provided by risk free liquid bonds is 5%. The EV is to be taken at a
multiple of 5 on EBITDA. The accountant has informed that the EBITDA of 90 includes an
extraordinary gain of 10 for the year, and a potential write off of preliminary sales promotion costs
of 20 are still pending. The internal assessment of rate of market return for the industry is 11%.
The FCFs for the next 3 years are as follows:
Y1 Y2 Y3
Future Cash flows 100 120 150
The pre-tax cost of debt is 12%. Assume a tax regime of 30%.

What is the potential value to be placed on X Pvt. Ltd?
Solution
The levered beta of the company will be 1.8[1+(1-0.3)*40/60)] = 2.64
The adjusted EBITDA would be 90 –10 – 20 = 60
The EV will be multiple of 5 on the 60 obtained above = 300
The Cost of equity in accordance with CAPM = r (f) + β (Rm – Rf)
= 5% + 2.64 (11% - 5%) = 20.84%
The WACC = Cost of Equity + Cost of Debt
= 20.84 (60/100) + 12.0 (1-0.3) (40/100) = 15.864
Finally, the future cash flows can be discounted at the WACC obtained above as under –
Y1 Y2 Y3
Future Cash flows 100 120 150
Discount factor 0.863 0.745 0.643
PVs of cash flows 86.30 89.40 96.45
VALUE OF THE FIRM 272.15
5. RELATIVE VALUATION
The three approaches that we saw to arriving at the value of an enterprise viz. the asset based,
the earnings based and the cash flow based are for arriving at the ‘intrinsic value’ of the same.
Relative Valuation is the method to arrive at a ‘relative’ value using a ‘comparative’ analysis to its
peers or similar enterprises. However, increasingly the contemporary financial analysts are using
relative valuation in conjunction to the afore-stated approaches to validate the intrinsic value
arrived earlier.
The Concept of ‘Relative Valuation’: One way to look at the practical implementation of fair value
within the valuation context would be to identify assets that are similar to the ones held by the
acquiree company so that the values can be compared. This would be a significant departure from
the ‘intrinsic value’ approach that we have seen until now. Trying to get a value that would be the
nearest to the market price would mean that the valuation of a particular portfolio, or a divestiture
in an entity, would happen at an agreeable price that fits into the normal distribution.
In one sense, we are indeed using the relative valuation in a limited approach when we speak
about expected market returns, or when we are adopting an index based comparative. The more
the asset pricing gets correlated to the similar assets in the market, the more inclusive it gets.
Thus, when we are comparing bonds, the closer the YTM of the bond to the government index of
return, the more credible it gets when it comes to pricing.
The Relative valuation, also referred to as ‘Valuation by multiples,’ uses financial ratios to derive at
the desired metric (referred to as the ‘multiple’) and then compares the sam e to that of comparable
firms. Comparable firms would mean the ones having similar asset and risk dispositions and
assumed to continue to do so over the comparison period. In the process, there may be
extrapolations set to the desired range to achieve the target set. To elaborate –
1. Find out the ‘drivers’ that will be the best representative for deriving at the multiple
2. Determine the results based on the chosen driver(s) through financial ratios
3. Find out the comparable firms, and perform the comparative analysis, and,
4. Iterate the value of the firm obtained to smoothen out the deviations
Step 1: Finding the correct driver that goes to determine the multiple is significant for relative
valuation as it sets the direction to the valuation approach. Thereby, one can have two sets of
multiple based approaches depending on the types of the drivers –
(a) Enterprise value based multiples, which would consist primarily of EV/EBITDA, EV/Invested
Capital and EV/Sales.
(b) Equity value based multiples, which would comprise of P/E ratio and Price Earning Growth
(PEG) Ratio.
We have already seen the concept and application of Enterprise Value in previous section.
However, in light of relative valuation, we can definitely add that whereas EV/EBITDA is a popular
ratio and does provide critical inputs, the EV/Invested Capital will be more appropriate to capital
intensive enterprises, and EV/Sales will be used by companies who are cash rich, have a huge
order book, and forecast organic growth through own capital.
The P/E has a celebrated status amongst Equity based multiples, and t he PEG (PE Ratio/ Growth
Rate i.e. the ratio of the PE to the expected growth rate of the firm) is more suitable where we are
doing relative valuation of either high growth or sunrise industries.
Step 2: Choosing the right financial ratio is a vital part of success of this model. A factor based
approach may help in getting this correct – for example – a firm that generates revenue mostly by
exports will be highly influenced by future foreign exchange fluctuations. A pure P/E based ratio
may not be reflective of this reality, which couldn’t pre-empt the impacts that Brexit triggered on
currency values. Likewise, an EV/Invested Capital would be a misfit for a company which may be
light on core assets, or if has significant investment properties.
Step 3: Arriving at the right mix of comparable firms. This is perhaps the most challenging of all
the steps – No two entities can be same – even if they may seem to be operating within the same
risk and opportunity perimeter. So, a software company ‘X’ that we are now comparing to a similar
sized company ‘Y’ may have a similar capital structure, a similar operative environment, and head
count size – so far the two firms are on even platform for returns forecast and beta values. On
careful scrutiny, it may be realized that the revenue generators are different – X may be deriving
its revenues from dedicated service contracts having Full Time Equivalent (FTE) pricing, whereas
Y earns through Unit Transfer Pricing (UTP) model. This additional set of information dramatically
changes the risk structure – and this is precisely what the discerning investor has to watch for. In
other words, take benchmarks with a pinch of salt.
Take another example – a firm is operating in a niche market, and that obviously leads to getting
comparable firms become a difficult task. In such cases, one may have to look beyond the current
operating market and identify similar structured companies from other industries.
The comparable firm can either be from a peer group operating within the same ris ks and
opportunities perimeter, or alternatively can be just take closely relevant firms and then perform a
regression to arrive at the comparable metrics. You would notice that in our example, the analyst
is adopting the later approach. Whereas the company ‘X’ will have to ignore ‘Y’ and search for a
similar revenue-risk based company. However, as a last resort, it may adopt a regression based
model as above.
Step 4: Iterate / extrapolate the results obtained to arrive at the correct estimate of the value of the
firm.
Thus, we can conclude that ‘Relative Valuation’ is a comparative driven approach that assumes
that the value of similar firms can form a good indicator for the value of the tested firm. There are
some assumptions that are inherent to this model –
i. The market is efficient
ii. The function between the fundamentals and the multiples are linear
iii. The firms that are comparable are similar to structure, risk and growth pattern
Further, we can approach Enterprise Value (EV) in two ways –
(a) Take Entity Value as the base, and then adjust for debt values for arriving the ‘EV’;
or
(b) Take a balance sheet based approach and arrive at EV.
Let’s apply the above concepts into a relative valuation illustration:
Illustration 2
A Ltd. made a Gross Profit of ` 10,00,000 and incurred Indirect Expenses of ` 4,00,000. The
number of issued Equity Shares is 1,00,000. The company has a Debt of ` 3,00,000 and Reserves
& Surplus to the tune of ` 5,00,000. The market related details are as follows:
Risk Free Rate of Return 4.5%
Market Rate of Return 12%
β of the Company 0.9
Determine:
(a) Per Share Earning Value of the Company.
(b) Equity Value of the company if applicable EBITDA multiple is 5.
Solution
(a) Capitalization Rate using CAPM
4.5% + 0.9(12% - 4.5%) = 11.25%
Calculation of Earning Value Per Share

(` 000)
Gross Profit 1000
Less: Indirect Expenses (400)
EBITDA 600
Earning Value of Company (600/ 0.1125) 5333.33
Number of Shares 1,00,000
Earning Value Per Share ` 53.33
(b) Equity Value of Company

(` 000)
EBITDA 600
EBITDA Multiple 5
Capitalized Value 3000
Less: Debt (300)
Add: Surplus Funds 500
Equity Value (Enterprise Value) 3200
Now let us see how EV can be arrived at using Balance Sheet approach in the following
illustration.
Illustration 3
The balance sheet of H K Ltd. is as follows:
` 000
Non-Current Assets 1000
Current Assets
Trade Receivables 500
Cash and cash equivalents 500
2000
Shareholders' funds 800

Long Term Debt 200
Current Liabilities and Provisions 1000
2000
The shares are actively traded and the Current Market Price (CMP) is ` 12 per share. Shareholder
funds represent 70,000 shares of ` 10 each and rest is retained earnings. Calculate the Enterprise
Value of HK Ltd.
Solution
Shares outstanding 70,000
CMP ` 12
Market Capitalization ` 8,40,000
Add: Debt ` 2,00,000
Less: Cash & Cash equivalents (` 5,00,000)
Enterprise Value (EV) ` 5 40 000
6. OTHER APPROACHES TO VALUE MEASUREMENT

6.1 Contemporary Approaches to Valuation
With businesses become exceedingly technology driven and managements now trying to position
themselves as ‘value creators’ thereby venturing into a ‘conglomerate’ way of thinking and running
business, the concept of value and valuation has also undergone a paradigm shift. T he tag for
‘MNC’ and inorganic growth has given rise to complex structures and tiers of management styles
and business houses. Of course, the more discerning of the lot would still stick to the original
game-plan as has been ruminated by us in the sections of this guide till now – separate the seed
from the chaff - by using the time honored ‘asset’ based, or ‘income’ based approaches or by
adopting a more mature ‘cash flow’ based one; and even a meticulous combination of all the three;
but it’s not common to find the bull market referring to, and analysts liberally using terminologies
like the ‘PEs’ and ‘Exit Multiples’, and to ‘LBOs’ and ‘Brand Value’.
It is worth noting here that some of these concepts used in valuation have been borne out of the
peculiarities of certain industries. An internet company would have virtually zero fixed assets – but
a robust online presence and a huge brand recall value. This would give rise to a new method of
valuation – Price Per Page visited. Or an online play store can be valued now using ‘Price Per
Subscriber’. However, like previously referred, the more discerning would still like to ask for the
cash to sales ratio, apply a DCF model before they put the money in the pot.
Another contemporary way to value a company is to have ‘Goodwill’ based approach – a retail
giant looking to desperately acquire a traditional mom-pop store in a particular hotspot that is
giving a run for its money could rightfully adopt this method – firstly take an asset based valuation,
and then value for the goodwill separately by linking a multiple to its annual sales or its footfall.
Price Earning Ratio (PER) - It equates the EPS (Earnings Per Share) to the price prevailing on
the stock market – the logic being that the market prices the stock based on its fundamentals, and
as a corollary you don’t have to look beyond the same to value the stock! So, assume the EPS of a
company is ` 40, and the average share price over the last quarter is ` 50, the PER would be
50/40 which works to 1.25. But we need to understand the important fact that PER is a relative
figure, and comparison across industries in the same sector can give a more median PER that
may be acceptable for valuation purposes.
LBOs (Leveraged Buy Outs) – The increasing complex nature of commerce and its applications
have given rise to a new category of ‘strategic investors’ – Private Equity (PE) firms who scout for
enterprises in the ‘rough’, acquire the same using a clever mix of debt and equity (typically at
70:30 debt to equity), and then targeting to sell the same within a medium term period, say 3 to 5
years. In the process, they leverage on the debt and create value (both perceived and real) , and
then they either spin off the management control to another entity for a price, or go for a n outright
sale.
Example
X is a small software company that is providing a niche data control and testing service having 60
employees and some steady contracts, which generates an EBIDTA of ` 100 Lacs per year. A
Venture Capitalist (VC) convinces the managing director of the company to sell off the majority
stake to him – valued at a premium of 100% per share over the Book Value plus one time goodwill
payoff of ` 50 Lacs, using an Income Based Valuation approach. Thus the total consideration
comes out ` 250 Lacs.
Next, the VC ropes a banker to pump in ` 200 Lacs for the acquisition-cum-expansion as well as
to do brand marketing, thereby making the company a visible player in the market. The gap of ` 50
Lacs is his contribution as promoter equity towards securities premium. Since the core operations
team is not dismantled, the company easily achieves a 20% average growth in each of the next 3
years.
At the end of the third year, the VC puts the company on the ‘Sale Block’ and is able to garner
interest of a leading MNC in the same. Assume if the exit multiple that the VC looks is at 7 times
the EBDAT. The entity value is hypothetically can be worked out as under –
(in ` Lacs)
Y0 Y1 Y2 Y3
EBIDTA 100.00 120.00 144.00 178.00
Less: Interest# 36.00 30.00 24.00 18.00
EBDTA 64.00 90.00 120.00 160.00
Less: Taxes @ 30% 19.20 27.00 36.00 48.00
EBDAT 44.80 63.00 84.00 112.00
Multiple 7
Capitalized Value at end of Y 3 784
Less: Debt (100)
Equity Value 684
# Debt principal assumed to be repayable linearly in 6 years.
One of the prime casualties in a LBO model is that the future cannot be predicted with e xactitude.
Thus, if at end of third year, the industry is caught in a cyclical slowdown, the VC will find itself
saddled with a huge loan and burgeoning interest costs difficult to recycle.
6.2 Chop-Shop Method
This approach attempts to identify multi-industry companies that are undervalued and would have
more value if separated from each other. In other words as per this approach an attempt is made
to buy assets below their replacement value. This approach involves following three steps :
Step 1: Identify the firm’s various business segments and calculate the average capitalization
ratios for firms in those industries.
Step 2: Calculate a “theoretical” market value based upon each of the average capitalization
ratios.
Step 3: Average the “theoretical” market values to determine the “chop-shop” value of the firm.
Illustration 4
Using the chop-shop approach (or Break-up value approach), assign a value for Cornett GMBH.
whose stock is currently trading at a total market price of €4 million. For Cornett, the accounting
data set forth in three business segments: consumer wholesaling, specialty services, and assorted
centers. Data for the firm’s three segments are as follows:
Business segment Segment sales Segment assets Segment income
Consumer wholesaling €1,500,000 € 750,000 €100,000
Specialty services €800,000 €700,000 €150,000
Assorted centers €2,000,000 €3,000,000 €600,000
Industry data for “pure-play” firms have been compiled and are summarized as follows:
Business segment Capitalization/ Capitalization/ Capitalization/
sales assets operating income
Consumer wholesaling 0.75 0.60 10.00
Specialty services 1.10 0.90 7.00
Assorted centers 1.00 0.60 6.00
Solution
Cornett, GMBH. – Break-up valuation
Business Segment Capital-to-Sales Segment Sales Theoretical Values
Consumer wholesaling 0.75 €1,500,000 €1,125,000
Specialty services 1.10 €800,000 €880,000
Assorted centers 1.00 €2,000,000 €2,000,000
Total value €4,005,000

Consumer wholesaling 0.60 €750,000 €450,000
Specialty services 0.90 €700,000 €630,000
Assorted centers 0.60 €3,000,000 €1,800,000

Consumer wholesaling 10.00 €100,000 €1,000,000
Specialty services 7.00 €150,000 €1,050,000
Assorted centers 6.00 €600,000 €3,600,000
4,005,000+ 2,880,000+ 5,650,000

Average theoretical value = = 4,178,333.33 say 4,178,000
3
Average theoretical value of Cornett GMBH. = €4,178,000
6.3 Economic Value Added (EVA)

Economic Value Added (EVA) is a holistic method of evaluating a company’s financial
performance, which means that EVA is used not only as a mere valuation technique, but also to
find the economic contribution of a company to the society at large. The core concept behind EVA
is that a company generates ‘value’ only if there is a creation of wealth in terms of returns in
excess of its cost of capital invested. EVA insists on separation of firm’s operation from its
financing. So if a company's EVA is negative, it means the company is not generating value from
the funds invested into the business. Conversely, a positive EVA shows a company is producing
value from the funds invested in it.
Why EVA? Up to now we have seen several financial performance metrics like ROI, ROCE, etc.
and also several approaches based on asset base / earnings / FCFs to finding out the ‘worth’ of
the entity. Then what is the need for EVA? Or in other words, what is the gap that EVA is trying to
fill in, that others couldn’t?
The answer to the above is the way EVA looks at performance of the ‘management’ of a company.
To elaborate, all the approaches seen up to now were just a function of ‘number-crunching’. But
EVA tries to make management more accountable to their individual decisions and the impact of
decisions on the path to progress of the company. Take a simple example – if there are two
dissimilar but equal risk opportunities that are feasible and the management needs to take a
decision, it would most probably go by the project which would break-even earlier. In choosing so
it is also cutting down the risk of future losses, fair enough. However, had the management
invested in both the projects, still it would have generated a positive IRR, though the second one
would have had a larger pay-back period. This impact of management’s strategic decision making
comes out evidently in EVA computations, whereas under the techniques seen till now, this
performance-driven aspect would have never been highlighted. The efficiency of the management
gets highlighted in EVA, by evaluating whether returns are generated to cover the cost of capital.
EVA is a performance measure for management of the company, and this is as evident in its
calculation formula as ‘the excess of returns over the weighted average cost of invested capital ‘.
The formula is as below –
EVA = NOPAT – (Invested Capital * WACC)
OR
NOPAT – Capital Charge
The concept NOPAT (Net Operating Profit After Tax) is nothing but EBIT minus tax expense. The
logic is that we are trying to find out the cash returns that business operations would make a fter
tax payments. Note that we have left depreciation untouched here – it being an operational
expense for the limited purposes of EVA. From this NOPAT we need to further identify the non-
cash expenses and adjust for the same to arrive at the ‘actual’ cash earnings. One common non-
cash adjustment would ‘provision for bad and doubtful debts’, as this would just be a book entry.
After arriving at the correct NOPAT, the next step would be finding the capital charge. This would
involve finding out
(a) Invested Capital – Which would be easy from published financials, as it would be the
difference between total assets subtracted by the non-interest bearing current liabilities, like
sundry creditors, billing in advance, etc. Care should be taken to do the adjustments for
non-cash elements like provision for bad and doubtful debts. Also it means equity plus long
term debt and generally at the start of the year. Further some changes or adjustment are
needed to be made on account of Non Cash Expenses both in Invested Capital and
NOPAT.
(b) Applying the company’s WACC on the invested capital arrived in step (a)
Finally the EVA is computed by reducing the capital charge as calculated by applying the WACC
on the invested capital from the adjusted NOPAT.
Illustration 5
Compute EVA of A Ltd. with the following information:
All Figure are in ` Lac
Profit and Loss Statement Balance Sheet
Revenue 1000 PPE 1000
Direct Costs -390 Current Assets 300
Selling, General &
Admin. Exp. (SGA) -200 1300
EBIT 410 Equity 700

Interest -10 Reserves 100
EBT 400 Non-Current Borrowings 100
Tax Expense -120 Current Liabilities & Provisions 400
EAT 280 1300
Assume Bad Debts provision of ` 20 Lac is included in the SGA, and same amount is reduced
from the trade receivables in current assets.
Also assume that the pre-tax Cost of Debt is 12%, Tax Rate is 30% and Cost of Equity (i.e.
shareholder’s expected return) is 8.45%.
Solution
Step I: Computation of NOPAT
NOPAT
EBIT 410
Less: Taxes -123
Add: Non-Cash Expenses 20
NOPAT 307
Step II: Finding out the Invested Capital:

Invested Capital
Total Assets 1300
Less: Non Interest bearing liabilities -400
900
Add: Non Cash adjustment 20
920
Note: It is assumed that the current liabilities also include the 100 of tax liab ility.
Step III: Compute the WACC
WACC = Cost of equity + Cost of debt
In this case, WACC = (800/900*8.45%) + [100/900*12% (1 - 0.30)] = 8.44%
Step IV: Find out the Capital Charge
Capital Charge = Invested Capital * WACC = 920 * 8.44% = 77.65
Step V: EVA = Adjusted NOPAT – Capital Charge = 307 – 77.65 = 229.35
6.4 Market Value Added (MVA)

The ‘MVA’ (Market Value Added) simply means the Current Market Value of the firm minus the
Invested Capital that we obtained above. Let the current MV of the firm be 1000. Hence MVA will
be –
1000 – 920 = 80.
MVA is an attempt to resolve some of the issues involved in EVA e.g. ignoring Value Drivers, Book
Value etc. Though MVA itself does not give any basis of share valuation but an alternative way to
gauge performance efficiencies of an enterprise, albeit from a market capitalization point of view,
the logic being that the market will discount the efforts taken by the management fairly. Hence, the
MVA of 80 arrived in example above is the true value added that is perceived by the market. In
contrast, EVA is a derived value added that is for the more discerning investor.
Since MVA represents market views regarding company’s future value generation c ompanies with
a higher MVA will naturally become the darlings of the share market, and would eventually become
‘pricey’ from a pure pricing perspective. In such cases, the EVA may also sometimes have a
slightly negative correlation as compared to MVA. But this will be a short term phenomenon as
eventually the gap will get closed by investors themselves. A stock going ex-dividend will exhibit
such propensities.
We can conclude that the main objective of EVA is thus to show management efficiency in
generating returns over and above the hurdle rate of invested capital.
6.5 Shareholder Value Analysis (SVA)
Now that we have seen ‘EVA’ and ‘MVA’, let’s proceed to see the concept of ‘SVA’ but questions
first – why SVA? And how does SVA behave?
We understand that the EVA is the residual that remains if the ‘capital charge’ is subtracted from
the NOPAT. The ‘residual’ if positive simply states that the profits earned are adequate to cover
the cost of capital.
However, is NOPAT the only factor that affects shareholder’s wealth? The answer is not a strict
‘no’, but definitely it is ‘inadequate’, as it doesn’t take future earnings and cash flows into account.
In other words, NOPAT is a historical figure, albeit a good one though, but cannot fully represent
for the future potencies of the entity. More importantly, it doesn’t capture the future in vestment
opportunities (or the opportunity costs, whichever way you look). SVA looks to plug in this gap by
tweaking the value analysis to take into its foray certain ‘drivers’ that can expand the horizon of
value creation. The key drivers considered are of ‘earnings potential in terms of sales, investment
opportunities, and cost of incremental capital.
The following are the steps involved in SVA computation:
(a) Arrive at the Future Cash Flows (FCFs) by using a judicious mix of the ‘value drivers’ as
discussed earlier
(b) Discount these FCFs using the WACC

(c) Add the terminal value to the present values computed in step (b)
(d) Current market value of non-core assets and marketable investment.
(e) Reduce the value of debt from the result in step (d) to arrive at value of eq uity.
Let’s take a progressive case study to run through the SVA calculations:
Step a.1: Using the appropriate value drivers, arrive at the operating cash flows:
(in $ Millions)
Y1 Y2 Y3 Y4 onwards
EBIT (growing at 5% yearly) 100.00 105.00 110.25 115.76
Interest Cost 5.00 6.00 7.00 8.00
EBT 95.00 99.00 103.25 107.76
Taxes @ 33% 31.35 32.67 34.07 35.56
EAT 63.65 66.33 69.18 72.20
Add back : Depreciation 5.00 5.00 6.00 7.00
Add back : One time write
offs 1.00 - - -
Operating Cash Flow 69.65 71.33 75.18 79.20
Step a(2):
Operating Cash Flow 69.65 71.33 75.18 79.20
Less: Forecasted Incremental Capital Invest. -- 12.00 6.00 9.00
Less: Forecasted Net Working Capital 5.00 5.00 6.00 7.00
Free Cash Flow (FCFs) 64.65 54.33 63.18 63.20
Step b: Applying the WACC to find out the discounted values:

Free Cash Flow (FCFs) 64.65 54.33 63.18 63.20
WACC (discount rate) @ 12% 0.89 0.80 0.71 0.64
Present Value of FCFs 57.54 43.46 44.86 40.45
Step c: Finding out the proper TV:

Multiplier for TV (1 ÷ 0.12) 8.33
Step d & e:
Total PVs 482.81
Add: Investment Property (at FV) 35.00
Less: Carrying cost of Debt (19.00)
Value of Equity 498.81
Thus, we observe that SVA brings out a futuristic sense of value for shareholders. In fact, this can
be a good benchmark for shareholders from a cash return on investment perspective too.
7. ARRIVING AT FAIR VALUE

The ultimate purpose of a potential acquirer of the controlling stake and / or the takeover of a
company is that ‘he would purchase the same at the fair price – no less no more’.
In fact, the approaches to valuation seen in this chapter along with the different methods of
performing a value added analysis is to identify entities that are ‘attractive’ in terms of the true
value to a potential investor.
A Chartered Accountant’s perspective to ‘fair value’ would automatically envisage a transaction to
be measured at the arm’s length. For a financial analyst, the term would be akin to the present
value of an entity in cash terms, and for a speculative investor, the term would represent the
arbitrage opportunities that open up among similar entities having dissimilar value numbers put to
it.
However, it’s an undeniable fact that in an upward boom time, the valuations defy fair value, for
example, the dot com boom had companies getting valued for astronomical sums. And when the
downturn arrived, some of these companies vanished and others were just able to stand up their
ground.
In this chapter we have discussed various methods of valuation. Though they have their own pros
and cons but it depends on the vision of the ultimate decision maker which method is suitable for
his/ her purpose. Further it can be said that there is no single answer to method of valuation as
correct one and it will be better if a range of values i.e. minimum acceptable by seller and
maximum payable by the buyer could be determined. Ultimately the final deal would depend on the
negotiation among the parties.
Accordingly, following approaches can be adopted to solve the question especially involving
evaluation and synthesis skill assessment requirements.
(i) Unless specified otherwise calculate valuation by as many as possible with available data.
(ii) Give comments on the valuation by each of these methods.
(iii) Supplement your conclusion with any additional information if available.
CASE STUDIES
A couple of real life case studies would help us to understand the Concepts better –
Case Study 1
The application of ‘valuation’ in the context of the merger of Vodafone with Idea Cell ular
Ltd:
The valuation methods deployed by the appointed CA firms for the merger were as follows:
(a) Market Value method: The share price observed on NSE (National Stock Exchange) for a
suitable time frame has been considered to arrive at the valuation.
(b) Comparable companies’ market multiple method: The stock market valuations of
comparable companies on the BSE and NSE were taken into account.
(c) NAV method: The asset based approach was undertaken to arrive at the net asset value of
the merging entities as of 31st December 2016.
Surprisingly, the DCF method was not used for valuation purposes. The reason stated was that the
managements to both Vodafone and Idea had not provided the projected (future) cash flows and
other parameters necessary for performing a DCF based valuation.
The final valuation done using methods a to c gave a basis to form a merger based on the ‘Share
Exchange’ method.
Above information extracted from: ‘Valuation report’ filed by Idea Cellular with NSE
However, let’s see how the markets have reacted to this news – the following article published in
The Hindu Business Line dated 20th March 2017 will give a fair idea of the same:
“Idea Cellular slumped 9.6 per cent as traders said the implied deal price in a planned merger with
Vodafone PLC's Indian operations under-valued the company shares. Although traders had
initially reacted positively to the news, doubts about Idea's valuations after the merger sent shares
downward.
Idea Cellular Ltd fell as much as 14.57 per cent, reversing earlier gains of 14.25 per cent, after the
telecom services provider said it would merge with Vodafone Plc's Indian operations.”
Hence, we can conclude that the valuation methods, though technically correct, may not elicit a
positive impact amongst stockholders. That is because there is something called as ‘perceiv ed
value’ that’s not quantifiable. It depends upon a majority of factors like analyst interpretations,
majority opinion etc.
Case Study 2
Valuation model for the acquisition of ‘WhatsApp’ by Facebook
Facebook announced the takeover of WhatsApp for a staggering 21.8 billion USD in 2015. The key
characteristics of WhatsApp that influenced the deal were –
(a) It is a free text-messaging service and with a $1 per year service fee, had 450 million users
worldwide close to the valuation date.
(b) 70% of the above users were active users.
(c) An aggressive rate of user account increase of 1 million users a day would lead to pipeline
of 1 billion users just within a year’s range.
The gross per-user value would thus, come to an average of USD 55, which included a 4 billion
payout as a sweetener for retaining WhatsApp employees post takeover. The payback for
Facebook will be eventually to monetize this huge user base with recalibrated charges on
international messaging arena. Facebook believes that the future lies in international, cross-
platform communications.
Above information extracted from the official website of business news agency ‘CNBC’
TEST YOUR KNOWLEDGE

1. Differentiate between EVA and MVA.
2. Relative Valuation is the method to arrive at a ‘relative’ value using a ‘comparative’ analysis
to its peers or similar enterprises. Elaborate this statement.
Practical Questions
1. ABC Company is considering acquisition of XYZ Ltd. which has 1.5 crores shares
outstanding and issued. The market price per share is ` 400 at present. ABC's average
cost of capital is 12%. Available information from XYZ indicates its expected cash accruals
for the next 3 years as follows:
Year ` Cr.
1 250
2 300
3 400
Calculate the range of valuation that ABC has to consider. (PV factors at 12% for years 1 to
3 respectively: 0.893, 0.797 and 0.712).
2. Eagle Ltd. reported a profit of ` 77 lakhs after 30% tax for the financial year 2011-12. An
analysis of the accounts revealed that the income included extraordinary items of ` 8 lakhs
and an extraordinary loss of `10 lakhs. The existing operations, except for the extraordinary
items, are expected to continue in the future. In addition, the results of the launch of a new
product are expected to be as follows:
` In lakhs
Sales 70
Material costs 20
Labour costs 12
Fixed costs 10

(i) Calculate the value of the business, given that the capitalization rate is 14%.
(ii) Determine the market price per equity share, with Eagle Ltd.‘s share capital being
comprised of 1,00,000 13% preference shares of ` 100 each and 50,00,000 equity
shares of ` 10 each and the P/E ratio being 10 times.
3. ABC Co. is considering a new sales strategy that will be valid for the next 4 years. They
want to know the value of the new strategy. Following information relating to the year which
has just ended, is available:
Income Statement `
Sales 20,000
Gross margin (20%) 4,000
Administration, Selling & distribution expense (10%) 2,000
PBT 2,000
Tax (30%) 600
PAT 1,400
Balance Sheet Information
Fixed Assets 8,000
Current Assets 4,000
Equity 12,000
If it adopts the new strategy, sales will grow at the rate of 20% per year for three years.
From 4th year onward it will stabilize. The gross margin ratio, Assets turnover ratio, the
Capital structure and the income tax rate will remain unchanged.
Depreciation would be at 10% of net fixed assets at the beginning of the year.
The Company’s target rate of return is 15%.
Determine the incremental value due to adoption of the strategy.
4. H Ltd. agrees to buy over the business of B Ltd. effective 1 st April, 2012.The summarized
Balance Sheets of H Ltd. and B Ltd. as on 31 st March 2012 are as follows:
Balance sheet as at 31st March, 2012 (In Crores of Rupees)
Liabilities: H. Ltd B. Ltd.
Paid up Share Capital
-Equity Shares of `100 each 350.00
Reserve & Surplus 950.00 25.00
Total 1,300.00 31.50
Assets:
Net Fixed Assets 220.00 0.50
Net Current Assets 1,020.00 29.00
Deferred Tax Assets 60.00 2.00
Total 1,300.00 31.50
H Ltd. proposes to buy out B Ltd. and the following information is provided to you as part of
the scheme of buying:
(1) The weighted average post tax maintainable profits of H Ltd. and B Ltd. for the last 4
years are ` 300 crores and ` 10 crores respectively.
(2) Both the companies envisage a capitalization rate of 8%.
(3) H Ltd. has a contingent liability of ` 300 crores as on 31 st March, 2012.
(4) H Ltd. to issue shares of ` 100 each to the shareholders of B Ltd. in terms of the
exchange ratio as arrived on a Fair Value basis. (Please consider weights of 1 and 3
for the value of shares arrived on Net Asset basis and Earnings capitalization
method respectively for both H Ltd. and B Ltd.)
You are required to arrive at the value of the shares of both H Ltd. and B Ltd. under:
(i) Net Asset Value Method
(ii) Earnings Capitalisation Method
(iii) Exchange ratio of shares of H Ltd. to be issued to the shareholders of B Lt d. on a
Fair value basis (taking into consideration the assumption mentioned in point
4 above.)
5. AB Ltd., is planning to acquire and absorb the running business of XY Ltd. The valuation is
to be based on the recommendation of merchant bankers and the consideration is to be
discharged in the form of equity shares to be issued by AB Ltd. As on 31.3.2006, the paid
up capital of AB Ltd. consists of 80 lakhs shares of ` 10 each. The highest and the lowest
market quotation during the last 6 months were ` 570 and ` 430. For the purpose of the
exchange, the price per share is to be reckoned as the average of the highest and lowest
market price during the last 6 months ended on 31.3.06.
XY Ltd.’s Balance Sheet as at 31.3.2006 is summarised below:
` lakhs
Sources
Share Capital
20 lakhs equity shares of `10 each fully paid 200
10 lakhs equity shares of `10 each, `5 paid 50
Loans 100
Total 350
Uses
Fixed Assets (Net) 150
Net Current Assets 200
350
An independent firm of merchant bankers engaged for the negotiation, have produced the
following estimates of cash flows from the business of XY Ltd.:
Year ended By way of ` lakhs
31.3.07 after tax earnings for equity 105
31.3.08 do 120
31.3.09 Do 125
31.3.10 Do 120
31.3.11 Do 100
Terminal Value estimate 200
It is the recommendation of the merchant banker that the business of XY Ltd. may be
valued on the basis of the average of (i) Aggregate of discounted cash flows at 8% and (ii)
Net assets value. Present value factors at 8% for years
1-5: 0.93 0.86 0.79 0.74 0.68
(i) Calculate the total value of the business of XY Ltd.
(ii) The number of shares to be issued by AB Ltd.; and
(iii) The basis of allocation of the shares among the shareholders of XY Ltd.
6. The valuation of Hansel Limited has been done by an investment analyst. Based on an
expected free cash flow of ` 54 lakhs for the following year and an expected growth rate of
9 percent, the analyst has estimated the value of Hansel Limited to be ` 1800 lakhs.
However, he committed a mistake of using the book values of debt and equity.
The book value weights employed by the analyst are not known, but you know that Hansel
Limited has a cost of equity of 20 percent and post tax cost of debt of 10 percent. The value
of equity is thrice its book value, whereas the market value of its debt is nine-tenths of its
book value. What is the correct value of Hansel Ltd?
7. Following information are available in respect of XYZ Ltd. which is expected to grow at a
higher rate for 4 years after which growth rate will stabilize at a lower level:
Base year information:
Revenue - ` 2,000 crores
EBIT - ` 300 crores
Capital expenditure - ` 280 crores
Depreciation - `200 crores
Information for high growth and stable growth period are as follows:
High Growth Stable Growth
Growth in Revenue & EBIT 20% 10%
Growth in capital expenditure and 20% Capital expenditure are
depreciation offset by depreciation
Equity beta 1.15 1
Market risk premium 6% 5%
Pre tax cost of debt 13% 12.86%
Debt equity ratio 1:1 2:3
For all time, working capital is 25% of revenue and corporate tax rate is 30%.
What is the value of the firm?
8. Following information is given in respect of WXY Ltd., which is expected to grow at a rat e of
20% p.a. for the next three years, after which the growth rate will stabilize at 8% p.a. normal
level, in perpetuity.
For the year ended March 31, 2014
Revenues ` 7,500 Crores
Cost of Goods Sold (COGS) ` 3,000 Crores
Operating Expenses ` 2,250 Crores
Capital Expenditure ` 750 Crores
Depreciation (included in Operating Expenses) ` 600 Crores
During high growth period, revenues & Earnings before Interest & Tax (EBIT) will grow at
20% p.a. and capital expenditure net of depreciation will grow at 15 % p.a. From year 4
onwards, i.e. normal growth period revenues and EBIT will grow at 8% p.a. and incremental
capital expenditure will be offset by the depreciation. During both high growth & normal
growth period, net working capital requirement will be 25% of revenues.
The Weighted Average Cost of Capital (WACC) of WXY Ltd. is 15%.
Corporate Income Tax rate will be 30%.
Required:
Estimate the value of WXY Ltd. using Free Cash Flows to Firm (FCFF) & WACC
methodology.
The PVIF @ 15 % for the three years are as below:
Year t1 t2 t3
PVIF 0.8696 0.7561 0.6575
9. With the help of the following information of Jatayu Limited compute the Economic Value
Added:
Capital Structure Equity capital ` 160 Lakhs
Reserves and Surplus ` 140 lakhs
10% Debentures ` 400 lakhs
Cost of equity 14%
Financial Leverage 1.5 times
Income Tax Rate 30%
10. RST Ltd.’s current financial year's income statement reported its net income after tax as `
25,00,000. The applicable corporate income tax rate is 30%.
Following is the capital structure of RST Ltd. at the end of current financial year:
`
Debt (Coupon rate = 11%) 40 lakhs
Equity (Share Capital + Reserves & Surplus) 125 lakhs
Invested Capital 165 lakhs
Following data is given to estimate cost of equity capital:
Equity Beta of RST Ltd. 1.36

Risk –free rate i.e. current yield on Govt. bonds 8.5%
Average market risk premium (i.e. Excess of return on market portfolio 9%
over risk-free rate)
Required:
(i) Estimate Weighted Average Cost of Capital (WACC) of RST Ltd.; and
(ii) Estimate Economic Value Added (EVA) of RST Ltd.
11. Tender Ltd has earned a net profit of ` 15 lacs after tax at 30%. Interest cost charged by
financial institutions was ` 10 lacs. The invested capital is ` 95 lacs of which 55% is debt.
The company maintains a weighted average cost of capital of 13%. Required,
(a) Compute the operating income.
(b) Compute the Economic Value Added (EVA).
(c) Tender Ltd. has 6 lac equity shares outstanding. How much dividend can the
company pay before the value of the entity starts declining?
12. The following information is given for 3 companies that are identical except for their capital
structure:
Orange Grape Apple
Total invested capital 1,00,000 1,00,000 1,00,000
Debt/assets ratio 0.8 0.5 0.2
Shares outstanding 6,100 8,300 10,000
Pre tax cost of debt 16% 13% 15%
Cost of equity 26% 22% 20%
Operating Income (EBIT) 25,000 25,000 25,000
The tax rate is uniform 35% in all cases.

(i) Compute the Weighted average cost of capital for each company.
(ii) Compute the Economic Valued Added (EVA) for each company.
(iii) Based on the EVA, which company would be considered for best investment? Give
reasons.
(iv) If the industry PE ratio is 11x, estimate the price for the share of each company.
(v) Calculate the estimated market capitalisation for each of the Companies.
13. Delta Ltd.’s current financial year’s income statement reports its net income as
` 15,00,000. Delta’s marginal tax rate is 40% and its interest expense for the year was
` 15,00,000. The company has ` 1,00,00,000 of invested capital, of which 60% is debt. In
addition, Delta Ltd. tries to maintain a Weighted Average Cost of Capital (WACC) of 12.6%.
(i) Compute the operating income or EBIT earned by Delta Ltd. in the current year.
(ii) What is Delta Ltd.’s Economic Value Added (EVA) for the current year?
(iii) Delta Ltd. has 2,50,000 equity shares outstanding. According to the EVA you
computed in (ii), how much can Delta pay in dividend per share before the value of
the company would start to decrease? If Delta does not pay any dividends, what
would you expect to happen to the value of the company?
14. The following data pertains to XYZ Inc. engaged in software consultancy business as on 31
December 2010.
($ Million)
Income from consultancy 935.00
EBIT 180.00
Less: Interest on Loan 18.00
EBT 162.00
Tax @ 35% 56.70
105.30
Balance Sheet
($ Million)
Liabilities Amount Assets Amount
Equity Stock (10 million 100 Land and Building 200
share @ $ 10 each) Computers & Softwares 295
Reserves & Surplus 325 Current Assets:
Loans 180 Debtors 150
Current Liabilities 180 Bank 100
Cash 40 290
785 785
With the above information and following assumption you are required to compute
(a) Economic Value Added ®
(b) Market Value Added.
Assuming that:
(i) WACC is 12%.
(ii) The share of company currently quoted at $ 50 each
15. Herbal Gyan is a small but profitable producer of beauty cosmetics using the plant Aloe
Vera. This is not a high-tech business, but Herbal’s earnings have averaged around ` 12
lakh after tax, largely on the strength of its patented beauty cream for removing the pimples.
The patent has eight years to run, and Herbal has been offered ` 40 lakhs for the patent
rights. Herbal’s assets include ` 20 lakhs of working capital and ` 80 lakhs of property,
plant, and equipment. The patent is not shown on Herbal’s books. Suppose Herbal’s cost of
capital is 15 percent. What is its Economic Value Added (EVA)?
16. Constant Engineering Ltd. has developed a high tech product which has reduced the
Carbon emission from the burning of the fossil fuel. The product is in high demand. The
product has been patented and has a market value of ` 100 Crore, which is not recorded in
the books. The Net Worth (NW) of Constant Engineering Ltd. is ` 200 Crore. Long term
debt is ` 400 Crore. The product generates a revenue of ` 84 Crore. The rate on 365 days
Government bond is 10 percent per annum. Market portfolio generates a return of 12
percent per annum. The stock of the company moves in tandem with the market. Calculate
Economic Value added of the company.
ANSWERS/ SOLUTIONS
1. VALUATION BASED ON MARKET PRICE
Market Price per share ` 400
Thus value of total business is (` 400 x 1.5 Cr.) ` 600 Cr.
VALUATION BASED ON DISCOUNTED CASH FLOW
Present Value of cash flows
(` 250 cr x 0.893) + (` 300 cr. X 0.797) + ( ` 400 cr. X 0.712 ) = ` 747.15 Cr.
Value of per share (` 747.15 Cr. / 1.5 Cr) ` 498.10 per share
RANGE OF VALUATION
Per Share ` Total `
Cr.
Minimum 400.00 600.00
Maximum 498.10 747.15
2. (i) Computation of Business Value

(` Lakhs)
77 110
Profit before tax
1 − 0.30
Less: Extraordinary income (8)
Add: Extraordinary losses 10
112
Profit from new product (` Lakhs)
Sales 70
Less: Material costs 20
Labour costs 12
Fixed costs 10 (42) 28
140.00
Less: Taxes @30% 42.00
Future Maintainable Profit after taxes 98.00
Relevant Capitalisation Factor 0.14
Value of Business (`98/0.14) 700
(ii) Determination of Market Price of Equity Share

Future maintainable profits (After Tax) ` 98,00,000
Less: Preference share dividends 1,00,000 shares of ` 100 @ 13% ` 13,00,000
Earnings available for Equity Shareholders ` 85,00,000
No. of Equity Shares 50,00,000
` 85,00,000 ` 1.70
Earning per share = =
50,00,000
PE ratio 10
Market price per share ` 17
3. Projected Balance Sheet

Year 1 Year 2 Year 3 Year 4
Fixed Assets (40% of Sales) 9,600 11,520 13,824 13,824
Current Assets (20% of Sales) 4,800 5,760 6,912 6,912
Total Assets 14,400 17,280 20,736 20,736
Equity 14,400 17,280 20,736 20,736
Projected Cash Flows:-

Year 1 Year 2 Year 3 Year 4
Sales 24,000 28,800 34,560 34,560
PBT (10% of sale) 2,400 2,880 3,456 3,456
PAT (70%) 1,680 2,016 2,419.20 2,419.20
Depreciation 800 960 1,152 1,382
Addition to Fixed Assets 2,400 2,880 3,456 1,382
Increase in Current Assets 800 960 1,152 -
Operating cash flow (FCFF) (720) (864) (1,036.80) 2,419.20
Projected Cash Flows:-
Present value of Projected Cash Flows:-
Cash Flows PVF at 15% PV
-720 0.870 -626.40
-864 0.756 -653.18
-1,036.80 0.658 -682.21
-1,961.79
Residual Value - 2419.20/0.15 = 16,128

Present value of Residual value = 16128/(1.15) 3
= 16128/1.521 = 10603.55
Total shareholders’ value = 10,603.55 – 1,961.79 = 8,641.76
Pre strategy value = 1,400 / 0.15 = 9,333.33
 Value of strategy = 8,641.76 – 9,333.33 = – 691.57
Conclusion: The strategy is not financially viable
4. (i) Net asset value

H Ltd. ` 1300 Crores − ` 300 Crores
= ` 285.71
3.50 Crores
B Ltd. ` 31.50 Crores
= ` 48.46
0.65 Crores
(ii) Earning capitalization value
H Ltd. ` 300 Crores / 0.08
= ` 1071.43
3.50 Crores
B Ltd. ` 10 Crores / 0.08
= ` 192.31
0.65 Crores
(iii) Fair value
H Ltd. ` 285.71 1 + ` 1071.43  3
= ` 875
4
B Ltd. ` 48.46  1 + ` 192.31 3
= ` 156.3475
4
Exchange ratio `156.3475/ `875 = 0.1787
H Ltd should issue its 0.1787 share for each share of B Ltd.
Note: In above solution it has been assumed that the contingent liability will
materialize at its full amount.
5. Price/share of AB Ltd. for determination of number of shares to be issued
= (` 570 + ` 430)/2 = ` 500
Value of XY Ltd based on future cash flow capitalization
(105x0.93)+(120x0.86)+(125x0.79)+(120x0.74)x(300x0.68) ` lakhs 592.40
Value of XY Ltd based on net assets ` lakhs 250.00
Average value (592.40+250)/2 421.20
No. of shares in AB Ltd to be issued ` 4,21,20,000/500 Nos. 84240
Basis of allocation of shares
Fully paid equivalent shares in XY Ltd. (20+5) lakhs 2500000
Distribution to fully paid shareholders 84240x20/25 67392
Distribution to partly paid shareholders 84240-67392 16848
6. Cost of capital by applying Free Cash Flow to Firm (FCFF) Model is as follows:-
FCFF1
Value of Firm = V 0 =
K c − gn
Where –
FCFF1 = Expected FCFF in the year 1
Kc= Cost of capital
gn = Growth rate forever
Thus, ` 1800 lakhs = ` 54 lakhs /(Kc-g)
Since g = 9%, then K c = 12%
Now, let X be the weight of debt and given cost of equity = 20% and cost o f debt = 10%,
then 20% (1 – X) + 10% X = 12%
Hence, X = 0.80, so book value weight for debt was 80%
 Correct weight should be 60 of equity and 72 of debt.
 Cost of capital = K c = 20% (60/132) + 10% (72/132) = 14.5455% and correct firm’s value
= ` 54 lakhs/(0.1454 – 0.09) = ` 974.73 lakhs.
7. High growth phase :
ke = 0.10 + 1.15 x 0.06 = 0.169 or 16.9%.
kd = 0.13 x (1-0.3) = 0.091 or 9.1%.
Cost of capital = 0.5 x 0.169 + 0.5 x 0.091 = 0.13 or 13%.
Stable growth phase :
ke = 0.09 + 1.0 x 0.05 = 0.14 or 14%.
kd = 0.1286 x (1 - 0.3) = 0.09 or 9%.
Cost of capital = 0.6 x 0.14 + 0.4 x 0.09 = 0.12 or 12%.
Determination of forecasted Free Cash Flow of the Firm (FCFF)
(` in crores)
Yr. 1 Yr. 2 Yr 3 Yr. 4 Terminal
Year
Revenue 2,400 2,880 3,456 4,147.20 4,561.92
EBIT 360 432 518.40 622.08 684.29
EAT 252 302.40 362.88 435.46 479.00
Capital Expenditure 96 115.20 138.24 165.89 -
Less Depreciation
∆ Working Capital 100.00 120.00 144.00 172.80 103.68
Free Cash Flow (FCF) 56.00 67.20 80.64 96.77 375.32

(` in crores)
Yr. 1 Yr. 2 Yr 3 Yr. 4 Terminal
Year
Revenue 2,400 2,880 3,456 4,147.20 4,561.92
EBIT 360 432 518.40 622.08 684.29
EAT 252 302.40 362.88 435.46 479.00
Add: Depreciation 240 288 345.60 414.72 456.19
492 590.40 708.48 850.18 935.19
Less: Capital Exp. 336 403.20 483.84 580.61 456.19
 WC 100.00 120.00 144.00 172.80 103.68
56.00 67.20 80.64 96.77 375.32
Present Value (PV) of FCFF during the explicit forecast period is:
FCFF (` in crores) PVF @ 13% PV (` in crores)

56.00 0.885 49.56
67.20 0.783 52.62
80.64 0.693 55.88
96.77 0.613 59.32
` 217.38
Terminal Value of Cash Flow

375.32
= ` 18,766.00Crores
0.12 - 0.10
PV of the terminal, value is:
1
` 18,766.00Crores x = ` 18,766.00Crores x 0.613 = ` 11,503.56 Crores
(1.13)4
The value of the firm is :

` 217.38 Crores + ` 11,503.56 Crores = ` 11,720.94 Crores
8. Determination of forecasted Free Cash Flow of the Firm (FCFF)

(` in crores)
Yr. 1 Yr. 2 Yr 3 Terminal Year

Revenue 9000.00 10800.00 12960.00 13996.80
COGS 3600.00 4320.00 5184.00 5598.72
Operating Expenses 1980.00* 2376.00 2851.20 3079.30
Depreciation 720.00 864.00 1036.80 1119.74
EBIT 2700.00 3240.00 3888.00 4199.04
Tax @30% 810.00 972.00 1166.40 1259.71
EAT 1890.00 2268.00 2721.60 2939.33
Capital Exp. – Dep. 172.50 198.38 228.13 -
∆ Working Capital 375.00 450.00 540.00 259.20
Free Cash Flow (FCF) 1342.50 1619.62 1953.47 2680.13
* Excluding Depreciation.
Present Value (PV) of FCFF during the explicit forecast period is:
FCFF (` in crores) PVF @ 15% PV (` in crores)

1342.50 0.8696 1167.44
1619.62 0.7561 1224.59
1953.47 0.6575 1284.41
3676.44
PV of the terminal, value is:

2680.13 1
x = ` 38287.57 Crore x 0.6575 = ` 25174.08 Crore
0.15 - 0.08 (1.15)3
The value of the firm is :

` 3676.44 Crores + ` 25174.08 Crores = ` 28,850.52 Crores
9. Financial Leverage = PBIT/PBT
1.5 = PBIT / (PBIT – Interest)

1.5 = PBIT / (PBIT – 40)
1.5 (PBIT – 40) = PBIT

1.5 PBIT – 60 = PBIT
1.5 PBIT – PBIT = 60
0.5 PBIT = 60
60
or PBIT = = `120 lakhs
0.5
NOPAT = PBIT – Tax = `120 lakhs (1 – 0.30) = `84 lakhs.

Weighted Average Cost of Capital (WACC)
= 14%  (300 / 700) + (1 – 0.30)  (10%)  (400 / 700) = 10%
EVA = NOPAT – (WACC  Total Capital)

EVA = `84 lakhs – 0.10  ` 700 lakhs
EVA = ` 14 lakhs
10. Cost of Equity as per CAPM

ke = Rf + β x Market Risk Premium
= 8.5% + 1.36 x 9%
= 8.5% + 12.24% = 20.74%
Cost of Debt kd = 11%(1 – 0.30) = 7.70%
E D
WACC (ko) = ke x + kd x
E+D E+D
125 40
= 20.74 x + 7.70 x = 15.71 + 1.87 = 17.58%
165 165
Taxable Income = ` 25,00,000/(1 - 0.30)
= ` 35,71,429 or ` 35.71 lakhs
Operating Income = Taxable Income + Interest
= ` 35,71,429 + ` 4,40,000
= ` 40,11,429 or ` 40.11 lacs
EVA = EBIT (1-Tax Rate) – WACC x Invested Capital
= ` 40,11,429 (1 – 0.30) – 17.58% x ` 1,65,00,000

= ` 28,08,000 – ` 29,00,700 = - ` 92,700
11. Taxable Income = ` 15 lac/(1-0.30)
= ` 21.43 lacs or ` 21,42,857
Operating Income = Taxable Income + Interest
= ` 21,42,857 + ` 10,00,000
= ` 31,42,857 or ` 31.43 lacs
EVA = EBIT (1-Tax Rate) – WACC x Invested Capital
= ` 31,42,857(1 – 0.30) – 13% x ` 95,00,000
= ` 22,00,000 – ` 12,35,000 = ` 9,65,000
` 9,65,000
EVA Dividend = = ` 1.6083
` 6,00,000
12. (i) Working for calculation of WACC
Orange Grape Apple

Total debt 80,000 50,000 20,000
Post tax Cost of debt 10.40% 8.45% 9.75%
Equity Fund 20,000 50,000 80,000
WACC
Orange: (10.4 x 0.8) + (26 x 0.2) = 13.52%
Grape: (8.45 x 0.5) + (22 x 0.5) = 15.225%
Apple: (9.75 x 0.2) + (20 x 0.8) = 17.95%
(ii)
Orange Grape Apple

WACC 13.52 15.225 17.95
EVA [EBIT (1-T)-(WACC x Invested Capital)] 2,730 1,025 -1,700
(iii) Orange would be considered as the best investment since the EVA of the company
is highest and its weighted average cost of capital is the lowest
(iv) Estimated Price of each company shares
Orange Grape Apple

EBIT (`) 25,000 25,000 25,000
Interest (`) 12,800 6,500 3,000
Taxable Income (`) 12,200 18,500 22,000
Tax 35% (`) 4,270 6,475 7,700
Net Income (`) 7,930 12,025 14,300
Shares 6,100 8,300 10,000
EPS (`) 1.30 1.45 1.43
Stock Price (EPS x PE Ratio) (`) 14.30 15.95 15.73
Since the three entities have different capital structures they would be exposed to
different degrees of financial risk. The PE ratio should therefore be adjusted for the
risk factor.
(v) Market Capitalisation
Estimated Stock Price (`) 14.30 15.95 15.73
No. of shares 6,100 8,300 10,000
Estimated Market Cap (`) 87,230 1,32,385 1,57,300
13. (i) Taxable income = Net Income /(1 – 0.40)
or, Taxable income = ` 15,00,000/(1 – 0.40) = ` 25,00,000
Again, taxable income = EBIT – Interest
or, EBIT = Taxable Income + Interest
= ` 25,00,000 + ` 15,00,000 = ` 40,00,000
(ii) EVA = EBIT (1 – T) – (WACC  Invested capital)
= ` 40,00,000 (1 – 0.40) – (0.126  ` 1,00,00,000)
= ` 24,00,000 – ` 12,60,000 = ` 11,40,000
(iii) EVA Dividend = ` 11,40,000/2,50,000 = ` 4.56
If Delta Ltd. does not pay a dividend, we would expect the value of the firm to increase
because it will achieve higher growth, hence a higher level of EBIT. If EBIT is higher, then
all else equal, the value of the firm will increase.
14. (a) Determination of Economic Value Added (EVA)
$ Million
EBIT 180.00
Less: Taxes @ 35% 63.00
Net Operating Profit after Tax 117.00
Less: Cost of Capital Employed [W. No.1] 72.60
Economic Value Added 44.40
(b) Determination of Market Value Added (MVA)
$ Million
Market value of Equity Stock [W. No. 2] 500
Equity Fund [W. No. 3] 425
Market Value Added 75
Working Notes:
(1) Total Capital Employed

Equity Stock $ 100 Million
Reserve and Surplus $ 325 Million
Loan $ 180 Million
$ 605 Million
WACC 12%
Cost of Capital employed $ 605 Million х 12% $ 72.60 Million
(2) Market Price per equity share (A) $ 50
No. of equity share outstanding (B) 10 Million
Market value of equity stock (A) х (B) $ 500 Million
(3) Equity Fund
Equity Stock $ 100 Million
Reserves & Surplus $ 325 Million
$ 425 Million
15. EVA = Income earned – (Cost of capital x Total Investment)

Total Investments
Particulars Amount
Working capital ` 20 lakhs
Property, plant, and equipment ` 80 lakhs
Patent rights ` 40 lakhs
Total ` 140 lakhs
Cost of Capital 15%

EVA= ` 12 lakh – (0.15 x ` 140 lakhs) = ` 12 lakh – ` 21 lakh = -` 9 lakh
Thus, Herbal Gyan has a negative EVA of ` 9 lakhs.
16. EVA = Income Earned – (Cost of Capital x Total Investment)
Total Investments
Amount (` Crore)
Net Worth 200.00
Long Term Debts 400.00
Patent Rights 100.00
Total 700.00
E D
WACC (ko) = ke  + kd 
E+D E+D
300 400
= 12  + 10 
700 700
= 5.14% + 5.71% = 10.85%
EVA = Profit Earned – WACC x Invested Capital
= ` 84 crore – 10.85% x ` 700 crore
= ` 8.05 crore
13
MERGERS, ACQUISITIONS &
CORPORATE
RESTRUCTURING
LEARNING OUTCOMES
❑ Conceptual Framework
❑ Rationale
❑ Forms
❑ Financial Framework
❑ Takeover Defensive Tactics
❑ Reverse Merger
❑ Divestiture
❑ Financial Restructuring
❑ Ownership Restructuring
❑ Premium and Discount
❑ Mergers and Acquisitions Failures
❑ Acquisition through shares
❑ Cross Border Mergers
1. CONCEPTUAL FRAMEWORK
Restructuring of business is an integral part of modern business enterprises. The globalization and
liberalization of Control and Restrictions has generated new waves of competition and free trade.
This requires Restructuring and Re-organisation of business organization to create new synergies
to face the competitive environment and changed market conditions.
Restructuring usually involves major organizational changes such as shift in corporate strategies.
Restructuring can be internally in the form of new investments in plant and machinery, Research
and Development of products and processes, hiving off of non-core businesses, divestment, sell-
offs, de-merger etc. Restructuring can also take place externally through Mergers and Acquisitions
(M&As) and by forming joint-ventures and having strategic alliances with other firms.
The aspects relating to expansion or contraction of a firm’s operations or changes in its assets or
financial or ownership structure are known as corporate re-structuring. While there are many forms
of corporate re-structuring, mergers, acquisitions and takeovers, financial restructuring and re-
organisation, divestitures de-mergers and spin-offs, leveraged buyouts and management buyouts
are some of the most common forms of corporate restructuring.
The most talked about subject of the day is Mergers & Acquisitions (M&A). In developed
economies, corporate Mergers and Acquisition is a regular feature. In Japan, the US and Europe,
hundreds of mergers and acquisition take place every year. In India, too, mergers and acquisition
have become part of corporate strategy today.
Mergers, acquisitions and corporate restructuring business in India have grown by leaps and
bounds in the last decade. From about $4.5 billion in 2004, the market for corporate control
zoomed to $ 13 billion in 2005 and reached to record $56.2 billion in 2016. This tremendous
growth was attributed to the fact that the foreign investors were looking for an alt ernative
destination, preferably a growing economy as their own country was reeling under the pressure of
recession. This was caused by the tough macro economic climate created due to Euro Zone crisis
and other domestic reasons such as inflation, fiscal deficit and currency depreciation.
The terms ‘mergers; ‘acquisitions’ and ‘takeovers’ are often used interchangeably in common
parlance. However, there are differences. While merger means unification of two entities into one,
acquisition involves one entity buying out another and absorbing the same . In India, in legal sense
merger is known as ‘Amalgamation’.
The amalgamations can be by merger of companies within the provisions of the Companies Act,
and acquisition through takeovers. While takeovers are regulated by SEBI, Mergers and
Acquisitions (M&A) deals fall under the Companies Act. In cross border transactions, international
tax considerations also arise.
Halsburry’s Laws of England defined amalgamation as a blending of two or more existing
undertakings, the shareholders of each amalgamating company becoming substantially the
MERGERS ACQUISITIONS & CORPORATE RESTRUCTURING 13.3
shareholders in the amalgamating company. Accordingly, in a merger, two or more companies

combine into a single unit.
The term “amalgamation” is used when two or more companies are amalgamated or where one is
merged with another or taken over by another. In Inland Steam Navigation Workers Union vs. R.S.
Navigation Company Ltd., it was observed that in case of amalgamation, the rights and liabilities of
a company are amalgamated into another so that the transferee company becomes vested with all
rights and liabilities of the transferor company.
An acquisition is when both the acquiring and acquired companies are still left standing as
separate entities at the end of the transaction. A merger results in the legal dissolution of one of
the companies, and a consolidation dissolves both of the parties and creates a new one, into
which the previous entities are merged.
In India corporate takeovers were started by Swaraj Paul when he tried to takeover Escorts. The
other major takeovers are that of Ashok Leyland by the Hindujas Shaw Wallace, Dunlop, and
Falcon Tyres by the Chabbria Group; Ceat Tyres by the Goenkas; and Consolidated Coffee by
Tata Tea. The BIFR arranged for the takeover of companies by giants like ITC, McDowells,
Lakshmi Machine Works, and the Somani Group.
Many new companies are being incorporated as a result of the fast growing industrialisation of the
country which is mainly dependent on agriculture. With the new trends of globalisation, not only in
this country but also worldwide, there has been increasing interaction of companies and persons of
one country with those of other countries. Today, corporate restructuring has gained momentum
and undertakings and companies are merging, demerging, divesting and taking in or taking over
companies and undertakings, both unregistered and registered, in India and o utside.
Against this corporate backdrop, mergers and acquisitions have to be encouraged in the interest of
the general public and for the promotion of industry and trade. At the same time the government
has to safeguard the interest of the citizens, the consumers and the investors on the one hand and
the shareholders, creditors and employees/workers on the other.
Chapter XV (Section 230 to 240) of Companies Act, 2013 (the Act) contains provisions on
‘Compromises, Arrangements and Amalgamations’, that covers compromise or arrangements,
mergers and amalgamations, Corporate Debt Restructuring, demergers, fast track mergers for
small companies/holding subsidiary companies, cross border mergers, takeovers, amalgamation of
companies in public interest etc.
Special restructuring processes such as ‘Reconstruction’ of sick industrial companies envisaged
by the Sick Industries (Special Provisions) Act, 1985 and ‘Revival’ of financially unviable
companies envisaged by sec 72A of the Income Tax Act, 1961. However, all su ch mergers and
acquisitions are also governed or controlled through relevant provisions of the Foreign Exchange
Management Act, 1999; Income Tax Act, 1961; Industries (Development and Regulation) Act,
1951, the Competition Act 2002; the restrictions imposed by other relevant Acts including SEBI
Act, 1992, as the case may be.
“Generally, where only one company is involved in a scheme and the rights of the shareholders
and creditors are varied, it amounts to reconstruction or reorganisation or scheme of
arrangement. In an amalgamation, two or more companies are fused into one by merger or by
one taking over the other. Amalgamation is a blending of two or more existing undertakings into
one undertaking, the shareholders of each blending company become substanti ally the
shareholders of the company which is to carry on the blended undertaking. There may be
amalgamation either by the transfer of two or more undertakings to a new company, or by the
transfer of one or more undertaking to an existing company. Strictly, ‘amalgamation’ does not
cover the mere acquisition by a company of the share capital of the other company which remains
in existence and continues its undertaking but the context in which the term is used may show that
it is intended to include such an acquisition.”
2. RATIONALE FOR MERGERS AND ACQUISITIONS

The most common reasons for Mergers and Acquisition (M&A) are:
• Synergistic operating economics: Synergy May be defined as follows:
V (AB) >V(A) + V (B).
In other words the combined value of two firms or companies shall be more than their
individual value Synergy is the increase in performance of the combined firm over what the
two firms are already expected or required to accomplish as independent firms (Mark L
Sirower of Boston Consulting Group, in his book “The Synergy Trap”). This may be result of
complimentary services economics of scale or both.
A good example of complimentary activities can a company may have a good networking of
branches and other company may have efficient production system. Thus the merged
companies will be more efficient than individual companies.
On similar lines, economies of large scale is also one of the reasons for synergy benefits.
The main reason is that, the large scale production results in lower average cost o f
production e.g. reduction in overhead costs on account of sharing of central services such
as accounting and finances, office executives, top level management, legal, sales
promotion and advertisement etc.
These economies can be “real” arising out of reduction in factor input per unit of output,
whereas pecuniary economics are realized from paying lower prices for factor inputs for
bulk transactions. Other factors for Synergies are as follows:
• Diversification: In case of merger between two unrelated companies would lead to
reduction in business risk, which in turn will increase the market value consequent upon the
reduction in discount rate/ required rate of return. Normally, greater the combination of
statistically independent or negatively correlated income streams of merged companies,
there will be higher reduction in the business risk in comparison to companies having
income streams which are positively correlated to each other.
• Taxation: The provisions of set off and carry forward of losses as per Income Tax Act may
be another strong reason for the merger and acquisition. Thus, there will be Tax saving or
reduction in tax liability of the merged firm. Similarly, in the case of acquisition the losses of
the target company will be allowed to be set off against the profits of the acquiring
company.
• Growth: Merger and acquisition mode enables the firm to grow at a rate faster than the
other mode viz., organic growth. The reason being the shortening of ‘Time to Market’. The
acquiring company avoids delays associated with purchasing of building, site, setting up of
the plant and hiring personnel etc.
• Consolidation of Production Capacities and increasing market power: Due to reduced
competition, marketing power increases. Further, production capacity is increa sed by the
combination of two or more plants.The following table shows the key rationale for some of
the well known transactions which took place in India in the recent past.
Rationale for M & A
Instantaneous growth, Snuffing out • Airtel – Loop Mobile (2014)
competition, Increased market share. (Airtel bags top spot in Mumbai Telecom Circle)
Acquisition of a competence or a • Google – Motorola (2011)
capability (Google got access to Motorola’s 17,000
issued patents and 7500 applications)
Entry into new markets/product • Airtel – Zain Telecom (2010)
segments (Airtel enters 15 nations of African Continent
in one shot)
Access to funds • Ranbaxy – Sun Pharma (2014)
(Daiichi Sankyo sold Ranbaxy to generate
funds)
Tax benefits • Burger King (US) – Tim Hortons(Canada)
(2014)
(Burger King could save taxes in future)
Instantaneous growth, Snuffing out • Facebook – Whatsapp (2014)
competition, Increased market share. (Facebook acquired its biggest threat in chat
space)
Acquisition of a competence or a • Flipkart – Myntra (2014)
capability (Flipkart poised to strengthen its competency
in apparel e-commerce market)
Entry into new markets/product • Cargill – Wipro (2013)
segments (Cargill acquired Sunflower Vanaspati oil
business to enter Western India Market)
Access to funds • Jaypee – Ultratech (2014)

(Jaypee sold its cement unit to raise funds for
cutting off its debt)
Tax benefits • Durga Projects Limited (DPL) – WBPDCL
(2014)
(DPL’s loss could be carry forward and setoff)
As mentioned above amalgamation is affected basically for growth and sometimes for image but
some of the objectives for which amalgamation may be resorted to are:
— Horizontal growth to achieve optimum size, to enlarge the market share, to curb competition
or to use unutilised capacity;
— Vertical combination with a view to economising costs and eliminating avoidable sales-tax
and/or excise duty;
— Diversification of business;
— Mobilising financial resources by utilising the idle funds lying with another company for the
expansion of business. (For example, nationalisation of banks provided this opportunity and
the erstwhile banking companies merged with industrial companies);
— Merger of an export, investment or trading company with an industrial company or vice
versa with a view to increasing cash flow;
— Merging subsidiary company with the holding company with a view to improving cash flow;
— Taking over a ‘shell’ company which may have the necessary industrial licences etc., but
whose promoters do not wish to proceed with the project.
An amalgamation may also be resorted to for the purpose of nourishing a sick unit in the group
and this is normally a merger for keeping up the image of the group.
3. FORMS (TYPES) OF MERGERS

A merger is generally understood to be a fusion of two companies. The t erm “merger” means the
dissolution of one or more companies or firms or proprietorships to form or get absorbed into
another company. By concept, merger increases the size of the undertakings. Following are major
types of mergers:
(i) Horizontal Merger: The two companies which have merged are in the same industry,
normally the market share of the new consolidated company would be larger and it is
possible that it may move closer to being a monopoly or a near monopoly to avoid
competition.
(ii) Vertical Merger: This merger happens when two companies that have ‘buyer-seller’
relationship (or potential buyer-seller relationship) come together.
(iii) Conglomerate Mergers: Such mergers involve firms engaged in unrelated type of
business operations. In other words, the business activities of acquirer and the target are
neither related to each other horizontally (i.e., producing the same or competiting products)
nor vertically (having relationship of buyer and supplier).In a pure conglomerate merger,
there are no important common factors between the companies in production, marketing,
research and development and technology. There may however be some degree of
overlapping in one or more of these common factors. Such mergers are in fact, unification
of different kinds of businesses under one flagship company. The purpose of merger
remains utilization of financial resources, enlarged debt capacity and also synergy of
managerial functions.
(iv) Congeneric Merger: In these mergers, the acquirer and the target companies are related
through basic technologies, production processes or markets. The acquired company
represents an extension of product-line, market participants or technologies of the acquirer.
These mergers represent an outward movement by the acquirer from its current business
scenario to other related business activities within the overarching industry structure.
(v) Reverse Merger: Such mergers involve acquisition of a public (Shell Company) by a
private company, as it helps private company to by-pass lengthy and complex process
required to be followed in case it is interested in going public.
(vi) Acquisition: This refers to the purchase of controlling interest by one company in the share
capital of an existing company. This may be by:
(i) an agreement with majority holder of Interest.
(ii) Purchase of new shares by private agreement.
(iii) Purchase of shares in open market (open offer)
(iv) Acquisition of share capital of a company by means of cash, issuance of shares.
(v) Making a buyout offer to general body of shareholders.
When a company is acquired by another company, the acquiring company has two choices ,
one, to merge both the companies into one and function as a single entity and , two, to
operate the taken-over company as an independent entity with changed management and
policies. ‘Merger’ is the fusion of two independent firms on co-equal terms. ‘Acquisition’ is
buying out a company by another company and the acquired company usually loses its
identity. Usually, this process is friendly.
Acquisition +NPV Normal gain Operating Entity

Industry gain Financial
of subsequent from the over the market leverage improvements Value
investment market
Source: Patricial Anslinger and Thomas E Copeland, “Growth through Acquisitions : A

Fresh look, Harvard Business Review Jan. – Feb -1996.
Acquisition of one of the business of a company, as a going concern by an agreement need
not necessarily be routed through court, if the transfer of business is to be accomplished
without allotting shares in the transferee company to the shareholders of the transferor
company. This would tantamount to a simple acquisition. In this case the tra nsferor
company continues to exist and no change in shareholding is expected. If the sale takes
place for a lumpsum consideration without attributing any individual values to any class of
assets, such sales are called slump sales. The capital gains arising on slump sales were
being exempt from income tax based on a decision of the Supreme Court of India.
4. FINANCIAL FRAMEWORK
4.1 Gains from Mergers or Synergy
The first step in merger analysis is to identify the economic gains from the merger. There are
gains, if the combined entity is more than the sum of its parts.
That is, Combined value > (Value of acquirer + Stand alone value of target)
The difference between the combined value and the sum of the values of individual companies is
usually attributed to synergy.
Value of acquirer + Stand alone value of target + Value of synergy = Combined value
There is also a cost attached to an acquisition. The cost of acquisition is the price premium paid
over the market value plus other costs of integration. Therefore, the net gain is the value of
synergy minus premium paid.
VA = `100
VB = ` 50
VAB = ` 175
Where, VA = Value of Acquirer
VB = Standalone value of target
And, VAB = Combined Value

So, Synergy = VAB – (VA + VB) = 175 - (100 + 50) = 25
If premium is ` 10, then, Net gain = Synergy – Premium = 25 – 10 = 15
Acquisition need not be made with synergy in mind. It is possible to make money from non -
synergistic acquisitions as well. As can be seen from Exhibit, operating improvements are a big
source of value creation. Better post-merger integration could lead to abnormal returns even when
the acquired company is in unrelated business. Obviously, managerial talent is the single most
important instrument in creating value by cutting down costs, improving revenues and operating
profit margin, cash flow position, etc. Many a time, executive compensation is tied to the
performance in the post-merger period. Providing equity stake in the company induces executives
to think and behave like shareholders.
Exhibit : Merger gains
Transaction cost
Value of synergy
Stand alone Value

quirer Combined value
Value of acquirer
Source : Patricia L Anslinger and Thomas E Copeland, ‘Growth Through Acquisitions : A

Fresh Look’, Harvard Business Review, Jan–Feb., 1996.
4.2 Scheme of Amalgamation or Merger
The scheme of any arrangement or proposal for a merger is the heart of the process and has to be
drafted with care.
There is no prescribed form for a scheme and it is designed to suit the terms and conditions
relevant to the proposal and should take care of any special feature peculiar to the arrangement.
An essential component of a scheme is the provision for vesting all the assets and liabilities of the
transferor company in its transferee company. If the transferee company does not want to take
over any asset or liability, the transferor company before finalising the draft scheme should
dispose it or settle. Otherwise, the scheme would be considered defective and incomplete and the
court would not sanction it.
It is equally important to define the effective date from which the scheme is intended to come into
operation. This would save time and labour in explaining to the court the intention behind using
several descriptions in the scheme. For accounting purposes, the amalgamation shall be effected
with reference to the audited accounts and balance sheets as on a particular date (which precedes
the date of notification) of the two companies and the transactions thereafter shall be pooled into a
common account.
Another aspect relates to the valuation of shares to decide the exchange ratio. Objections have
been raised as to the method of valuation even in cases where the scheme had been approved by
a large majority of shareholders and the financial institutions as lenders. The courts have declared
their unwillingness to engage in a study of the fitness of the mode of valuation. A High Court
stated: “There are bound to be differences of opinion as to what the correct value of the shares of
the company is. Simply because it is possible to value the share in a manner different from the one
adopted in a given case, it cannot be said that the valuation agreed upon has been unfair.”
Similarly, in the case of Hindustan Lever the Supreme Court held that it would not interfere with
the valuation of shares when more than 99 per cent of the shareholders have approved the
scheme and the valuations having been perused by the financial institutions.
The position of employees also has to be clearly set out. The employment contract is a contract of
personal service which may not be transferred by an order of court and may not ha ve an effect of
making an employee of the transferor company as an employee of the transferee company. The
scheme should provide for the transfer of all employees to the transferee company on the same
terms and conditions of service without any break in service. In the event of the transferee
company not willing to absorb any of the employees through the merger, the transferor company
should settle those employees with applicable law before the scheme is put through.
4.3 Financial Evaluation
Financial evaluation addresses the following issues:
(a) What is the maximum price that should be for the target company?
(b) What are the principal areas of Risk?
(c) What are the cash flow and balance sheet implications of the acquisition? And ,
(d) What is the best way of structuring the acquisition?
4.4 Arranging Finance for Acquisition

Once the Definitive Agreement is signed, the Company Secretarial aspects relating to putting
through the acquisition process will be taken up by the legal and secretarial department of both the
companies. Side by side, the CFO of the acquiring company will move to the next stage which is
‘Financing the Acquisition’.
One of the most important decisions is how to pay for the acquisition – cash or stock or part of
each and this would be part of the Definitive Agreement. If the acquisition is an ‘all equity deal’, the
CFO’s can breathe easy. However, if cash payout is significant, the acquirer has to plan for
financing the deal. Sometimes acquirers do not pay all of the purchase consideratio n as, even
though they could have sufficient funds. This is part of the acquisition strategy to keep the war
chest ready for further acquisitions. Another reason to pay by shares would be when the acquirer
considers that their company’s shares are ‘over priced’ in the market.
Financing the acquisition can be quite challenging where the acquisition is a LBO. Many times
strong companies plan to shore up their long term funds subsequent to the takeover. The
immediate funding is accomplished with bridge financing.
5. TAKEOVER DEFENSIVE TACTICS

Normally acquisitions are made friendly, however when the process of acquisition is unfriendly
(i.e., hostile) such acquisition is referred to as ‘takeover’). Hostile takeover arises when the Board
of Directors of the acquiring company decide to approach the shareholders of the target company
directly through a Public Announcement (Tender Offer) to buy their shares consequent to the
rejection of the offer made to the Board of Directors of the target company.
5.1 Take Over Strategies
Other than Tender Offer the acquiring company can also use the following techniques:
• Street Sweep: This refers to the technique where the acquiring company accumulates
larger number of shares in a target before making an open offer. The advantage is that the
target company is left with no choice but to agree to the proposal of acquirer for takeover.
• Bear Hug: When the acquirer threatens the target company to make an open offer, the
board of target company agrees to a settlement with the acquirer for change of control.
• Strategic Alliance: This involves disarming the acquirer by offering a partnership rather than
a buyout. The acquirer should assert control from within and takeover the target company.
• Brand Power: This refers to entering into an alliance with powerful brands to displace the
target’s brands and as a result, buyout the weakened company.
5.2 Defensive Tactics

A target company can adopt a number of tactics to defend itself from hostile takeover through a
tender offer.
• Divestiture - In a divestiture the target company divests or spins off some of its businesses
in the form of an independent, subsidiary company. Thus, reducing the attractiveness of the
existing business to the acquirer.
• Crown jewels - When a target company uses the tactic of divestiture it is said to sell the
crown jewels. In some countries such as the UK, such tactic is not allowed once the deal
becomes known and is unavoidable.
• Poison pill - Sometimes an acquiring company itself becomes a target when it is bidding
for another company. The tactics used by the acquiring company to make itself unattractive
to a potential bidder is called poison pills. For instance, the acquiring company may issue
substantial amount of convertible debentures to its existing shareholders to be converted at
a future date when it faces a takeover threat. The task of the bidder would become difficult
since the number of shares to having voting control of the company increases substantially.
• Poison Put - In this case the target company issue bonds that encourage holder to cash in
at higher prices. The resultant cash drainage would make the target unattractive.
• Greenmail - Greenmail refers to an incentive offered by management of the target company
to the potential bidder for not pursuing the takeover. The management of the target
company may offer the acquirer for its shares a price higher than the market price.
• White knight - In this a target company offers to be acquired by a friendly company to
escape from a hostile takeover. The possible motive for the management of the target
company to do so is not to lose the management of the company. The hostile acquirer may
change the management.
• White squire - This strategy is essentially the same as white knight and involves sell out of
shares to a company that is not interested in the takeover. As a consequence, the
management of the target company retains its control over the company.
• Golden parachutes - When a company offers hefty compensations to its managers if they
get ousted due to takeover, the company is said to offer golden parachutes. This reduces
acquirer’s interest for takeover.
• Pac-man defence - This strategy aims at the target company making a counter bid for the
acquirer company. This would force the acquirer to defend itself and consequ ently may call
off its proposal for takeover.
It is needless to mention that hostile takeovers, as far as possible, should be avoided as they are
more difficult to consummate. In other words, friendly takeover are better course of action to
follow.
6. REVERSE MERGER
In ordinary case, the company taken over is the smaller company; in a 'reverse takeover', a
smaller company gains control of a larger one. The concept of takeover by reverse bid, or of
reverse merger, is thus not the usual case of amalgamation of a sick unit which is non-viable with
a healthy or prosperous unit but is a case whereby the entire undertaking of the healthy and
prosperous company is to be merged and vested in the sick company which is non -viable. A
company becomes a sick industrial company when there is erosion in its net worth. This alternative
is also known as taking over by reverse bid.
The three tests should be fulfilled before an arrangement can be termed as a reverse takeover is
specified as follows:
(i) the assets of the transferor company are greater than the transferee company,
(ii) equity capital to be issued by the transferee company pursuant to the acquisition exceeds
its original issued capital, and
(iii) the change of control in the transferee company through the introduction of a minority
holder or group of holders.
This type of merger is also known as ‘back door listing’. This kind of merger has been started as
an alternative to go for public issue without incurring huge expenses and passing through
cumbersome process. Thus, it can be said that reverse merger leads to the following benefits for
acquiring company:
• Easy access to capital market.
• Increase in visibility of the company in corporate world.
• Tax benefits on carry forward losses acquired (public) company.
• Cheaper and easier route to become a public company.
7. DIVESTITURE
It means a company selling one of the portions of its divisions or undertakings to another company
or creating an altogether separate company. There are various reasons for divestment or
demerger viz.,
(i) To pay attention on core areas of business;
(ii) The Division’s/business may not be sufficiently contributing to the revenues;
(iii) The size of the firm may be too big to handle;
(iv) The firm may be requiring cash urgently in view of other investment opportunities.
7.1 Seller’s Perspective

It is necessary to remember that for every buyer there must be a seller. Although the methods of
analysis for selling are the same as for buying, the selling process is termed divestiture. The
decision to sell a company is at least as important as buying one but selling generally lacks the
kind of planning that goes into buying. Quite often, the decision and the choice of the buyer is
arbitrary, resulting in a raw deal for the selling company’s shareholders. It is important to
understand that selling needs the same set of skills required for buying. At some point of time the
executives of a company may have to take the decision to divest a division There is nothing wrong
in selling a division if it is worth more to someone else. The decision to sell may be prompted by
poor growth prospects for a division or consolidation in the industry. Given the fact that the need to
sell may arise any time, it makes sense for executives to be prepared. More spec ifically,
executives need to know their company’s worth. Consideration may be given to strengths and
weakness in production, marketing, general management, value of synergy to potential buyers,
value of brand equity, skill base of the organisation, etc.
To summarise, the following are some of the ‘sell-side’ imperatives
• Competitor’s pressure is increasing.
• Sale of company seems to be inevitable because company is facing serious problems like:
▪ No access to new technologies and developments
▪ Strong market entry barriers. Geographical presence could not be enhanced
▪ Badly positioned on the supply and/or demand side
▪ Critical mass could not be realised
▪ No efficient utilisation of distribution capabilities
▪ New strategic business units for future growth could not be developed
▪ Not enough capital to complete the project
• Window of opportunity: Possibility to sell the business at an attractive price
• Focus on core competencies
• In the best interest of the shareholders – where a large well known firm brings-up the
proposal, the target firm may be more than willing to give-up.
7.2 Different Forms
Different ways of divestment or demerger or divestitures are as follows:
7.2.1 Sell off / Partial Sell off
A sell off is the sale of an asset, factory, division, product line or subsidiary by one entity to
another for a purchase consideration payable either in cash or in the form of securities. Partial Sell
off, is a form of divestiture, wherein the firm sells its business unit or a subsidiary to another
because it deemed to be unfit with the company’s core business strategy.
Normally, sell-offs are done because the subsidiary doesn't fit into the parent company's core
strategy. The market may be undervaluing the combined businesses due to a lack of synergy
between the parent and the subsidiary. So, the management and the board decide that the
subsidiary is better off under a different ownership. Besides getting rid of an unwanted subsidiary,
sell-offs also raise cash, which can be used to pay off debts. In the late 1980s and early 1990s,
corporate raiders used debt to finance acquisitions. Then, after making a purchase they used to
sell-off its subsidiaries to raise cash to service the debt. The raiders' method certainly makes
sense if the sum of the parts is greater than the whole. When it isn't, deals are unsuccessful.
7.2.2 Spin-off
In this case, a part of the business is separated and created as a separate firm. The existing
shareholders of the firm get proportionate ownership. So, there is no change in ownership and the
same shareholders continue to own the newly created entity in the same proportion as previously
in the original firm. The management of spin-off division is however, parted with. Spin-off does not
bring fresh cash. The reasons for spin off may be:
(i) Separate identity to a part/division.
(ii) To avoid the takeover attempt by a predator by making the firm unattractive to him since a
valuable division is spun-off.
(iii) To create separate Regulated and unregulated lines of business.
Example: Kishore Biyani led Future Group spin off its consumer durables business, Ezone, into a
separate entity in order to maximise value from it.
7.2.3 Split-up
This involves breaking up of the entire firm into a series of spin off (by creating separate legal
entities). The parent firm no longer legally exists and only the newly created entities survive. For
instance, a corporate firm has 4 divisions namely A, B, C, D. All these 4 divisions shall be split-up
to create 4 new corporate firms with full autonomy and legal status. The origi nal corporate firm is
to be wound up. Since de-merged units are relatively smaller in size, they are logistically more
convenient and manageable. Therefore, it is understood that spin-off and split-up are likely to
enhance shareholders value and bring efficiency and effectiveness.
7.2.4 Equity Carve outs
This is like spin off, however, some shares of the new company are sold in the market by making a
public offer, so this brings cash. More and more companies are using equity carve-outs to boost
shareholder value. A parent firm makes a subsidiary public through an initial public offering (IPO) of
shares, amounting to a partial sell-off. A new publicly listed company is created, but the parent keeps a
controlling stake in the newly traded subsidiary.
A carve-out is a strategic avenue a parent firm may take when one of its subsidiaries is growing
faster and carrying higher valuations than other businesses owned by the parent. A carve -out
generates cash because shares in the subsidiary are sold to the public, but the issue also unlocks
the value of the subsidiary unit and enhances the parent's shareholder value.
The new legal entity of a carve-out has a separate board, but in most carve-outs, the parent
retains some control over it. In these cases, some portion of the parent firm's board of directors
may be shared. Since the parent has a controlling stake, meaning that both firms have common
shareholders, the connection between the two is likely to be strong. That said, sometimes
companies carve-out a subsidiary not because it is doing well, but because it is a burden. Such an
intention won't lead to a successful result, especially if a carved-out subsidiary is too loaded with
debt or trouble, even when it was a part of the parent and lacks an established track reco rd for
growing revenues and profits.
7.2.5 Demerger or Division of Family-Managed Business
Around 80 per cent of private sector companies in India are family-managed companies. The
family-owned companies are, under extraordinary pressure to yield control to professional
managements, as, in the emerging scenario of a liberalised economy the capital markets are
broadening, with attendant incentives for growth. So, many of these companies are arranging to
hive off their unprofitable businesses or divisions with a view to meeting a variety of succession
problems.
Even otherwise, a group of such family-managed companies may undertake restructuring of its
operations with a view also to consolidating its core businesses. For this, the first step that may
need to be taken is to identify core and non-core operations within the group. The second step
may involve reducing interest burden through debt restructuring along with sale of surplus assets.
The proceeds from the sale of assets may be employed for expanding by ac quisitions and
rejuvenation of its existing operations. The bottom line is that an acquisition must improve
economies of scale, lower the cost of production, and generate and promote synergies. Besides
acquisitions, therefore, the group may necessarily have to take steps to improve productivity of its
existing operations.
8. FINANCIAL RESTRUCTURING
Financial restructuring refers to a kind of internal changes made by the management in Assets and
Liabilities of a company with the consent of its various stakeholders. This is a suitable mode of
restructuring for corporate entities who have suffered from sizeable losses over a period of time.
Consequent upon losses the share capital or net worth of such companies get substantially
eroded. In fact, in some cases, the accumulated losses are even more than the share capital and
thus leading to negative net worth, putting the firm on the verge of liquidation. In order to revive
such firms, financial restructuring is one of the techniques to bring into health such firms which are
having potential and promise for better financial performance in the years to come. To achieve this
desired objective, such firms need to re-start with a fresh balance sheet free from losses and
fictitious assets and show share capital at its true worth.
To nurse back such firms a plan of restructuring need to be formulated involving a number of legal
formalities (which includes consent of court, and other stake-holders viz., creditors, lenders and
shareholders etc.). An attempt is made to do refinancing and rescue financing while Restructuring.
Normally equity shareholders make maximum sacrifice by foregoing certain accrued benefits,
followed by preference shareholders and debenture holders, lenders and creditors etc. The
sacrifice may be in the form of waving a part of the sum payable to various liability holders. The
foregone benefits may be in the form of new securities with lower coupon rates so as to reduce
future liabilities. The sacrifice may also lead to the conversion of debt into equ ity. Sometime,
creditors, apart from reducing their claim, may also agree to convert their dues into securities to
avert pressure of payment. These measures will lead to better financial liquidity. The financial
restructuring leads to significant changes in the financial obligations and capital structure of
corporate firm, leading to a change in the financing pattern, ownership and control and payment of
various financial charges.
In nutshell it may be said that financial restructuring (also known as intern al re-construction) is
aimed at reducing the debt/payment burden of the corporate firm. This results into
(i) Reduction/Waiver in the claims from various stakeholders;
(ii) Real worth of various properties/assets by revaluing them timely;
(iii) Utilizing profit accruing on account of appreciation of assets to write off accumulated losses
and fictitious assets (such as preliminary expenses and cost of issue of shares and
debentures) and creating provision for bad and doubtful debts. In practice, the fin ancial re-
structuring scheme is drawn in such a way so that all the above requirements of write off
are duly met. The following illustration is a good example of financial restructuring.
Illustration 1
The following is the Balance-sheet of XYZ Ltd. as on March 31st, 2013.
(` in lakh)
6 lakh Equity Shares of `100/- each 600 Land & Building 200
2 Lakh 14% Preference shares of `100/- 200 Plant & Machinery 300
each Furniture & Fixtures 50
13% Debentures 200 Inventory 150
Debenture Interest accrued and Payable 26 Sundry debtors 70
Loan from Bank 74 Cash at Bank 130
Trade Creditors 300 Preliminary Expenses 10
Cost of Issue of debentures 5
Profit & Loss A/c 485
1,400 1,400
The Company did not perform well and has suffered sizable losses during the last few years.
However, it is now felt that the company can be nursed back to health by proper financial
restructuring and consequently the following scheme of reconstruction has been devised:
(i) Equity shares are to be reduced to ` 25/- per share, fully paid up;
(ii) Preference shares are to be reduced (with Dividend rate of 10%) to equal number of shares
of `50 each, fully paid up.
(iii) Debenture holders have agreed to forego interest accrued to them. Beside this, they have
agreed to accept new debentures carrying a coupon rate of 9%.
(iv) Trade creditors have agreed to forgo 25 per cent of their existing claim; for the balance sum
they have agreed to convert their claims into equity shares of ` 25/- each.
(v) In order to make payment for bank loan and augment the working capital, the company
issues 6 lakh equity shares at ` 25/- each; the entire sum is required to be paid on
application. The existing shareholders have agreed to subscribe to the new issue.
(vi) While Land and Building is to be revalued at ` 250 lakh, Plant & Machinery is to be written
down to ` 104 lakh. A provision amounting to ` 5 lakh is to be made for bad and doubtful
debts.
You are required to show the impact of financial restructuring/re-construction. Also, prepare the
new balance sheet assuming the scheme of re-construction is implemented in letter and spirit.
Solution
Impact of Financial Restructuring
(i) Benefits to XYZ Ltd.
` in lakhs
(a) Reduction of liabilities payable
Reduction in Equity Share capital (6 lakh shares x `75 per share) 450
Reduction in Preference Share capital (2 lakh shares x `50 per 100
share)
Waiver of outstanding Debenture Interest 26
Waiver from Trade Creditors (`300 lakhs x 0.25) 75
651
(b) Revaluation of Assets
Appreciation of Land and Building (`250 lakhs - `200 lakhs) 50
701
(ii) Amount of ` 701 lakhs utilized to write off losses, fictious assets and overvalued assets.
` in lakhs
Writing off Profit and Loss account 485
Cost of issue of debentures 5
Preliminary expenses 10
Provision for bad and doubtful debts 5
Revaluation of Plant and Machinery (`300 lakhs – `104 lakhs) 196
701
Balance sheet of XYZ Ltd as at_______ (after re-construction)

(` in lakhs)
21 lakhs Equity Shares of `25/- each 525 Land & Building 250
2 lakhs 10% Preference shares of `50/- 100 Plant & Machinery 104
each
9% Debentures 200 Furnitures& 50
Fixtures
Inventory 150
Sundry debtors 70
-5 65
Cash-at-Bank 206
(Balancing figure)*
825 825
*Opening Balance of `130/- lakhs + Sale proceeds from issue of new equity shares `150/-
lakhs – Payment of bank loan of `74/- lakhs = `206 lakhs.
It is worth mentioning that financial restructuring is unique in nature a nd is company specific. It is
carried out, in practice when all shareholders sacrifice and understand that the restructured firm
(reflecting its true value of assets, capital and other significant financial para meters) can now be
nursed back to health. This type of corporate restructuring helps in the revival of firms that
otherwise would have faced closure/liquidation.
9. OWNERSHIP RESTRUCTURING
9.1 Going Private
This refers to the situation wherein a listed company is converted into a private company by buying
back all the outstanding shares from the markets.
Example: The Essar group successfully completed Essar Energy Plc delisting process from
London Stock Exchange in 2014.
Going private is a transaction or a series of transactions that convert a pu blicly traded company
into a private entity. Once a company goes private, its shareholders are no longer able to trade
their stocks in the open market.
A company typically goes private when its stakeholders decide that there are no longer significant
benefits to be garnered as a public company. Privatization will usually arise either when a
company's management wants to buy out the public shareholders and take the company pr ivate (a
management buyout), or when a company or individual makes a tender offer to buy most or all of
the company's stock. Going private transactions generally involve a significant amount of debt.
9.2 Management Buy Outs
Buyouts initiated by the management team of a company are known as a management buyout. In
this type of acquisition, the company is bought by its own management team.
MBOs are considered as a useful strategy for exiting those divisions that does not form part of the
core business of the entity.
9.3 Leveraged Buyout (LBO)
An acquisition of a company or a division of another company which is financed entirely or partially
(50% or more) using borrowed funds is termed as a leveraged buyout. The target company no
longer remains public after the leveraged buyout; hence the transaction is also known as going
private. The deal is usually secured by the acquired firm’s physical assets.
The intention behind an LBO transaction is to improve the operational efficiency of a firm and
increase the volume of its sales, thereby increasing the cash flow of the firm. This extra cash flow
generated will be used to pay back the debt in LBO transaction. After an, LBO the target entity is
managed by private investors, which makes it easier to have a close control of its operational
activities. The LBOs do not stay permanent. Once the LBO is successful in increasing its prof it
margin and improving its operational efficiency and the debt is paid back, it will go public again.
Companies that are in a leading market position with proven demand for product, have a strong
management team, strong relationships with key customers and suppliers and steady growth are
likely to become the target for LBOs. In India the first LBO took place in the year 2000 when Tata
Tea acquired Tetley in the United Kingdom. The deal value was Rs 2135 crores out of which
almost 77% was financed by the company using debt. The intention behind this deal was to get
direct access to Tetley’s international market. The largest LBO deal in terms of deal value (7.6
Billion) by an Indian company is the buyout of Corus by Tata Steel.
9.4 Equity buyback
This refers to the situation wherein a company buys back its own shares back from the market.
This results in reduction in the equity capital of the company. This strengthen the promoter’s
position by increasing his stake in the equity of the company.
The buyback is a process in which a company uses its surplus cash to buy shares from the public.
It is almost the opposite of initial public offer in which shares are issued to the public for the first
time. In buyback, shares which have already been issued are bought back from the public and
once the shares are bought back, they get absorbed and cease to exist.
For example, a company has one crore outstanding shares and owing a huge cash pile of ` 5
crores. Since, the company has very limited investment options it dec ides to buyback some of its
outstanding shares from the shareholders, by utilizing some portion of its surplus cash.
Accordingly, it purchases 10 lakh shares from the existing shareholders by paying ` 20 per share.
total cash of say, ` 2 crore. The process of buyback can be shown with the help of following
diagram:
INITIAL PUBLIC OFFER (IPO) BUY-BACK
COMPANY COMPANY
SHARES
CASH
SHARES
CASH
INVESTORS INVESTORS
Example Cairn India bought back 3.67 crores shares and spent nearly ` 1230 crores by May
2014.
Effects of Buyback
There are several effects or consequences of buyback some of which are as follows:
(i) It increases the proportion of shares owned by controlling shareholders as the number of
outstanding shares decreases after the buyback.
(ii) Earning Per Share (EPS) escalates as the number of shares reduces leading the market
price of shares to step up.
(iii) A share repurchase also effects a company’s financial statements as follows:

(a) In balance sheet, a share buyback will reduce the company’s total assets position as
cash holdings will be reduced and consequently as shareholders' equity reduced it
results in reduction on the liabilities side by the same amount.
(b) Amount spent on share buybacks shall be shown in Statement of Cash Flows in the
“Financing Activities” section, as well as from the Statement of Changes in Equity
or Statement of Retained Earnings.
(iv) Ratios based on performance indicators such as Return on Assets (ROA) and Return on
Equity (ROE) typically improve after a share buyback. This can be understood with the help
of following Statement showing Buyback Effect of a hypothetical company using ` 1.50
crore of cash out of total cash of ` 2.00 for buyback.
Before Buyback After Buyback (`)
Cash (`) 2,00,00,000 50,00,000
Assets (`) 5,00,00,000 3,50,00,000
Earnings (`) 20,00,000 20,00,000
No. of Shares outstanding (Nos.) 10,00,000 9,00,000
Return on Assets (%) 4.00% 5.71%
Earnings Per Share (EPS) (`) 2.00 2.22
As visible from the above figure, the company's cash pile has been reduced from ` 2 crore to ` 50
lakh after the buyback because cash is an asset, this will lower the total assets of the company
from ` 5 crore to ` 3.5 crore. Now, this leads to an increase in the company’s ROA, even though
earnings have not changed. Prior to the buyback, its ROA was 4% but after the repurchase, ROA
increases to 5.71%. A similar effect can be seen in the EPS, which increases from ` 2.00 to
` 2.22.
10. PREMIUM AND DISCOUNT

Premiums and discounts are typically attached to a business valuation, based on the situation. These
could be market share premium, controlling stake premium, brand value premium, small player
discount or unlisted company discount. In addition, it may be required to work out various potential
scenarios in each methodology and arrive at the likely probabilities of each while deriving the values .
Timing is very critical while divesting a business since valuation depends on the timing. Timing of
sale is crucial keeping in mind economic cycles (deal valuation takes into consideration GDP
growth rates), stock market situations (which would decide market multiples), global situations (like
a war or terrorist attacks).
In times like the above, the price expectations between the buyer and the seller would widely vary.
For example, during a stock market lull, there could be a situation where there are more buyers but
not sellers due to the low valuation.
The basis for M&A is the expectation of several future benefits arising out of synergies between
businesses. There is a risk involved in realizing this synergy value. This could be due to corporate,
market, economic reasons or wrong estimation of the benefits/synergies. A key case in point here
is the high valuations at which internet companies were acquired in the year 2000 (such as
Satyam Infoway acquisition of India World).
As observed in the chapter on Corporate Valuation it is also important to try and work out
valuations from as many of the above methods as possible and then try and see which
methodology is to be taken in and which are to be rejected and derive a range of values for the
transaction in different situations in case one is called upon to assist in advising the transaction
valuation. Some methods like Net Asset Value or past Earnings Based methods may prove
inadequate in case of growing businesses or those with intangible assets.
11. CASE STUDIES

Some case studies are listed below based on actual Indian situations and an analysis based on
published data is given below.
11.1 Case Study – Rationale for M & A and Valuation – Largest Customer
Base
Bharti Airtel to buy Loop Mobile for ` 700 crores
In February 2014, Bharti Airtel (“Airtel”), a leading global telecommunications services provider
with operations in 20 countries across Asia and Africa has announced to buy Mumbai based Loop
Mobile. Although the price was not stated it is understood to be in the region of around ` 700
crores. The proposed association will undergo seamless integration once definitive agreements
are signed and is subject to regulatory and statutory approvals. Under the agreement, Loop
Mobile’s 3 million subscribers in Mumbai will join Airtel’s over 4 million subscribers, creating an
unmatched mobile network in Mumbai. The merged network will be thw largest by customer base
in the Mumbai circle. The proposed transaction will bring together Loop Mobile’s 2G/EDGE
enabled network supported by 2,500 plus cell sites, and Airtel’s 2G and 3G network supported by
over 4000 cell sites across Mumbai. It will also offer subscribers the widest exclusive retail reach
with 220 outlets that will enable best in class customer service. The agreement will ensure
continuity of quality services to Loop Mobile’s subscribers, while offering them the added benefits
of Airtel’s innovative product portfolio and access to superior services, innovative products like 3G,
4G, Airtel Money, VAS and domestic/international roaming facilities. Loop Mobile subscribers will
become part of Airtel’s global network that serves over 289 million customers in 20 countries.
Globally, Airtel is ranked as the fourth largest mobile services provider in terms of subscribers.
(Based on Press release hosted on Bharti Airtel’s website)
11.2 Case Study – Valuation Analysis

Listed software company X to merge with unlisted company Y
Company X and company Y were in the software services business. X was a listed company and Y
was an unlisted entity. X and Y decided to merge in order to benefit from marketing. Operational
synergies and economies of scale. With both companies being mid-sized, the merger would make
them a larger player, open new market avenues, bring in expertise in more verticals and wi der
management expertise. For company X, the benefit lies in merging with a newer company with
high growth potential and for company Y, the advantage was in merging with a business with track
record, that too a listed entity.
The stock swap ratio considered after valuation of the two businesses was 1:1.
Several key factors were considered to arrive at this valuation. Some of them were very unique to
the businesses and the deal:
• Valuation based on book value net asset value would not be appropriate for X an d Y since
they are in the knowledge business, unless other intangibles assets like human capital,
customer relationships etc. could be identified and valued.
• X and Y were valued on the basis of
a) expected earnings b) market multiple.
• While arriving at a valuation based on expected earnings, a higher growth rate was
considered for Y, it being on the growth stage of the business life cycle while a lower rate
was considered for X, it being in the mature stage and considering past growth.
• Different discount factors were considered for X and Y, based on their cost of capital, fund
raising capabilities and debt-equity ratios.
• While arriving at a market-based valuation, the market capitalization was used as the
starting point for X which was a listed company. Since X had a significant stake in Z,
another listed company, the market capitalization of X reflected the value of Z as well.
Hence the market capitalization of Z had to be removed to the extent of X’s stake from X’s
value as on the valuation date.
• Since Y was unlisted, several comparable companies had to be identified, based on size,
nature of business etc. and a composite of their market multiples had to be estimated as a
surrogate measure to arrive at Y’s likely market capitalization, as if it were list ed. This value
had to be discounted to remove the listing or liquidity premium since the surrogate measure
was estimated from listed companies.
• After arriving at two sets of values for X and Y, a weighted average value was calculated
after allotting a higher weight for market based method for X (being a listed company) and a
higher weight for earnings based method for Y (being an unlisted but growing
company).The final values for X and Y were almost equal and hence the 1:1 ratio was
decided.
11.3 Case Study – Rationale for M&A and Valuation – Acquisition at

Premium
(1) Ranbaxy to Bring In Daiichi Sankyo Company Limited as Majority Partner – June 2008
Ranbaxy Laboratories Limited, among the top 10 generic companies in the world and India’s
largest pharmaceutical company, and Daiichi Sankyo Company Limited, one of the largest
pharmaceutical companies in Japan, announced that a binding Share Purchase and Share
Subscription Agreement was entered into between Daiichi Sankyo, Ranbaxy and the Singh family,
the largest and controlling shareholders of Ranbaxy (the “Sellers”), pursuant to which Daiichi
Sankyo will acquire the entire shareholding of the Sellers in Ranbaxy and further seek to acquire
the majority of the voting capital of Ranbaxy at a price of ` 737 per share with the total transaction
value expected to be between US$ 3.4 to US$ 4.6 billion (currency exchange rate: US$ 1 = ` 43).
On the post closing basis, the transaction would value Ranbaxy at US$ 8.5 billion.
The Share Purchase and Share Subscription Agreement has been unanimously approved by the
Boards of Directors of both companies. Daiichi Sankyo is expected to acquire the majority equity
stake in Ranbaxy by a combination of:
(i) purchase of shares held by the Sellers,
(ii) preferential allotment of equity shares,
(iii) an open offer to the public shareholders for 20% of Ranbaxy’s shares, as per Indian
regulations, and
(iv) Daiichi Sankyo’s exercise of a portion or all of the share warrants to be issued on a
preferential basis. All the shares/warrants will be acquired at a price of ` 737 per share.
This purchase price represents a premium of 53.5% to Ranbaxy’s average daily closing price on
the National Stock Exchange for the three months ending on June 10, 2008 and 31.4% to such
closing price on June 10, 2008.
The deal will be financed through a mix of bank debt facilities and existing cash resources of
Daiichi Sankyo. It is anticipated that the transaction will be accretive to Daiichi Sankyo’s EPS and
Operating income before amortization of goodwill in the fiscal year ending March 31, 2010 (FY
2009). EPS and Operating income after amortization of goodwill are expected to see an accretive
effect in FY 2010 and FY 2009, respectively.
Why would Daiichi Sankyo wanted to aquire majority stake in Ranbaxy, that too at a premium?
Ranbaxy's drive to become a research-based drug developer and major manufacturer has led it
straight into the welcoming arms of Japan's Daiichi Sankyo, that’s why it announced to buy a
majority stake in the Indian pharma company. After Sankyo completes a buyout of the founding
Singh family's stake in the company, Ranbaxy will become a subsidiary operation. The deal is
valued at $4.6 billion and will create a combined company worth about $30 billion. That move
positions Daiichi Sankyo to become a major supplier of low-priced generics to Japan's aging
population and accelerates a trend by Japanese pharma companies to enter emerging Asian
markets, where they see much of their future growth. The acquisition stunned investors and
analysts alike, who were caught off guard by a bold move from a conservative player in the
industry. (Source: Fiercebiotech.com)
Also, from a financial and business perspective Ranbaxy’s revenues and bottom lines were
continuously on the rise since 2001; the R&D expenses were stable around 6%. In FY 2007 the
company had revenues of 69,822 million INR ($1.5billion) excluding other income. The earnings of
the company were well diversified across the globe; however, the emerging world contributed
heavily to the revnues (Emerging 54%, Developed 40%, others 6%). However, the Japan market,
with low generics penetration contributed just $25 million to the top line. The company had just
begun to re-orient its strategy in favour of the emerging markets. The product, patent and API
portfolio of the company was strong. The company made 526 product filings and received 457
approvals globally. The Company than served customers in over 125 countries and had an
expanding international portfolio of affiliates, joint ventures and alliances, operations in 56
countries. (Source: ukessays.com)
(2) Sun Pharma to acquire Ranbaxy in US$ 4 billion – April 2014
Sun Pharmaceutical Industries Ltd. and Ranbaxy Laboratories Ltd today announced that they have
entered into definitive agreements pursuant to which Sun Pharma will acquire 100% of Ranbaxy in
an all-stock transaction. Under these agreements, Ranbaxy shareholders will receive 0.8 share of
Sun Pharma for each share of Ranbaxy. This exchange ratio represents an implied value of ` 457
for each Ranbaxy share, a premium of 18% to Ranbaxy’s 30-day volume-weighted average share
price and a premium of 24.3% to Ranbaxy’s 60-day volume-weighted average share price, in each
case, as of the close of business on April 4, 2014. The transaction is expected to represent a tax-
free exchange to Ranbaxy shareholders, who are expected to own approximately 14% of the
combined company on a pro forma basis. Upon closing, Daiichi Sankyo will become a significant
shareholder of Sun Pharma and will have the right to nominate one director to Sun Pharma’s
Board of Directors.
What prompted Daiichi Sankyo to decide on divestiture of the Indian Pharma company which it had
barely acquired just about six years ago?
It has been a rocky path for Japanese pharma major Daiichi Sankyo ever since it acquired a 63.5
per cent stake in Indian drug maker Ranbaxy in June 2008. The Japanese drug-maker was
expected to improve manufacturing process at Ranbaxy, which has a long history of run-ins with
drug regulators in the US, its largest market, going back to 2002. Instead, serious issues persisted,
resulting in a ban by the US Food & Drug Administration on most drugs and pharmaceutical
ingredients made in Ranbaxy’s four Indian manufacturing plants. Soon after the deal was inked, in
September 2008, the US drug regulator - Food and Drug Administration - accused Ranbaxy of
misrepresenting data and manufacturing deficiencies. It issued an import ban on Ranbaxy,
prohibiting the export of 30 drugs to the US, within three months after Daiic hi announced the
acquisition. Following this, Ranbaxy’s sales in the US shrank almost by a fourth, and its stock price
slumped to over a fifth of the acquisition price. It has since taken Ranbaxy four years to reach a
settlement with the US regulatory authorities. In 2013, The Company agreed to pay a fine of $500
million after admitting to false representation of data and quality issues at its three Indian plants
supplying to the US market. The company’s problems in the US are far from done with. It
continues to face challenges in securing timely approval for its exclusive products in the US
markets. (Source: thehindubusinessline.com)
Why Sun Pharma take interest in acquiring Ranbaxy?
The combination of Sun Pharma and Ranbaxy creates the fifth-largest specialty generics company
in the world and the largest pharmaceutical company in India. The combined entity will have 47
manufacturing facilities across 5 continents. The transaction will combine Sun Pharma’s proven
complex product capabilities with Ranbaxy’s strong global footprint, leading to significant value
creation opportunities. Additionally, the combined entity will have increased exposure to emerging
economies while also bolstering Sun Pharma’s commercial and manufacturing presence in the
United States and India. It will have an established presence in key high-growth emerging markets.
In India, it will be ranked No. 1 by prescriptions amongst 13 different classes of specialist doctors.
Also, from a financial and business perspective on a pro forma basis, the combined entity’s
revenues are estimated at US$ 4.2 billion with EBITDA of US$ 1.2billion for the twelve month
period ended December 31, 2013.The transaction value implies a revenue multiple of 2.2 based on
12 months ended December 31, 2013. Sun Pharma expects to realize revenue and operating
synergies of US$ 250 millionby third yearpost closing of the transaction. These synergies are
expected to result primarily from topline growth, efficient procurement and supply chain
efficiencies.
(Major contents are derived from press releases hosted on website of Ranbaxy)
In summary, the challenge to valuing for M&As is to obtain a thorough understanding of the
business dynamics of both the parties, the rationale for the merger, the industry dynamics, the
resulting synergies as well as the likely risks of the transaction are required in order to ensure that
the valuation is such that it is a ‘win-win’ for both the parties and is financially viable. It is also
important to understand that there are no hard and fast rules since one is projecting the future
which is ‘unknown’ based on current understanding. Therefore, experience, good judgment and
diligence are important in working out values.
11.4 Case Study – Rationale for M&A and Valuation – Turnaround
JLR acquisition by Tata motors and How JLR was turned around by Tata's
Tata’s growth strategy was to consolidate position in domestic market & expand international
footprint through development of new products by:
─ Leveraging in house capabilities
─ Acquisitions & collaborations to gain complementary capabilities
Why Tata Motors want to acquire Jaguar Land Rover (JLR)?

There are several reasons why Tata Motors want to acquire Jaguar Land Rover (JLR)
(i) Long term strategic commitment to Automotive sector.
(ii) Build comprehensive product portfolio with a global footprint immediately.
(iii) Diversify across markets & products segments.
(iv) Unique opportunity to move into premium segment.
(v) Sharing the best practices between Jaguar, Land rover and Tata Motors in the future.
Introduction of JLR
(i) Global sales of around 300,000 units, across 169 countries
(ii) Global revenue of $15 Billion
(iii) Nine Car lines, designed, engineered and manufactured in the UK.
(iv) 16000 employees
TATA Motor’s position after acquiring JLR
Tata Motors’ market value plunged to 6,503.2 crore, with the stock hitting rock bottom
126.45 on 20 November 2008 (after the acquisition of JLR in 2008)
How Tata Motors turned JLR around

(i) Favorable Currency Movements
— Significant export in dollars- North America
— Net importers of Euros in terms of material
(ii) Improved market sentiments.
— Retail volumes in America, Europe and China improved
(iii) Introduction of newer, more fuel-efficient and stylish models
— Launch of XK & New XZ Jaguar models
(iv) Refreshing the existing ones
(v) Revival of demand in the firm’s key markets such as the UK, the US and Europe
(vi) Costs reductions at various levels and the formation of 10-11 cross-functional teams
(vii) A number of management changes, including new heads at JLR, were made
(viii) Workforce being trimmed since July 2008 by around 11,000
There were five key issues that persuaded Tata Motors to go ahead
Firstly, Ford had pumped in a great deal of cash to improve quality and it was just a matter of time
before this made a difference.
Secondly, JLR had very good automobile plants.
Thirdly, the steadfastness of the dealers despite losses over the past four -five years.
Fourthly, Jaguar cars had already started moving up the ranks of the annual JD Power customer
satisfaction rankings.
And, lastly, besides that, there was a crop of great new models in the pipeline, among them the
Jaguar XJ and XF and the upcoming Land Rover, which convinced Tata Motors that JLR was on
the verge of change.
11.5 Case Study on Demerger – Rationale - Dabur India Ltd.
Dabur India Ltd. ("Dabur") initiated its demerger exercise in January 2003, after the agreement of
the Board of Directors to hive off the Pharma business into a new company named Dabur Pharm a
Ltd. ("DPL"). After the demerger, Dabur concentrated on its core competencies in personal care,
healthcare, and Ayurvedic specialties, while DPL focused on its expertise in oncology formulations
and bulk drugs. The demerger would allow investors to benchmark performance of these two
entities with their respective industry standards.
Results of Demerger Analysis.

Dabur FMCG Dabur Pharma Composite
Beta Equity 0.50 0.53 0.56
Re 11.52% 11.74% 11.95%
Rd(1 – t) 5.20% 5.20% 5.20%
D/E 0.22 0.07 0.4
E/V 0.82 0.93 0.71
D/V 0.18 0.07 0.29
WACC 10.38% 11.31% 10.02%
ROCE 27.70% 8.35% 19.40%
EVA 51.16 -8.49 47.08
The results of the analysis

The Dabur FMCG business unlocked value for shareholders, since the EVA of the FMCG business
was more than that of the composite business. Dabur Pharma had a negative EVA, clearly
indicating that its capital was not properly used in the composite company.
The total EVA of the FMCG and Pharma division was lesser than that of the composite business
indicating a negative synergy between the two divisions. The EVA disparity between the demerged
units is expected as FMCG and Pharma are two distinctly different businesses, where FMCG is a
low capital intensity business, the pharmaceutical business requires higher capital due to R&D
activities.
11.6 Case Study on Demerger – Rationale - Bajaj Auto Ltd.
The Board of Directors of Bajaj Auto Ltd agreed to a demerger on 17th May 2007. Under the
scheme, BAL, the parent company, would be renamed Bajaj Holdings and Investment Ltd ("BHIL" )
and the business was to be demerged into two new incorporated subsidiaries – Bajaj Auto Ltd
("BAL") and Bajaj Finserv Ltd ("BFL"). The auto and manufacturing businesses of the company
would be held by BHIL while the wind power project, investments in ins urance companies and
consumer finance would go to BFL. All the shareholders of the parent company became
shareholders in the new companies and were issued shares of the two new companies in the
ratio 1:1.
Results of Demerger Analysis
Composite Bajaj Auto Bajaj Fin. BHIL
Services
Beta Equity 0.67 0.72 0.77 0.53
Re 12.67% 13.04% 13.39% 11.71%
Rd(1 – t) 5.20% 5.20% 5.20% 5.20%
D/E 0.30 0.84 0.26 0.19

E/V 0.77 0.54 0.79 0.84
D/V 0.23 0.46 0.21 0.16
WACC 10.95% 9.46% 11.70% 10.67%
ROCE 18.84% 39.13% 4.35% 6.79%
EVA 138.17 474.91 -139.40 -156.46
The results of the analysis

The Auto division unlocked value for shareholders (its EVA more than that of composite business).
BFL and BHIL showed negative EVA, clearly indicating that capital was not properly used by them.
The sum total EVA of the three divisions after the demerger is greater than the composite business
EVA, indicating a successful value unlocking for the shareholders. Both these cases highlight that
demergers can unlock significant shareholder value. The markets also reacted positively, with both
scrips appreciating when the news of the demerger broke out.
12. MERGERS AND ACQUISITIONS FAILURES

There are five principal steps in a successful M&A programme.
1. Manage the pre-acquisition phase.
2. Screening candidates.
3. Eliminate those who do not meet the criteria and value the rest.
4. Negotiate.
5. Post-merger integration.
During the pre-acquisition phase, the acquirer should maintain secrecy about its intentions.
Otherwise, the resulting price increase due to rumours may kill the deal.
Academic studies indicate that success in creating value through acquisitions in a competitive
market is extremely difficult. Jensen and Ruback (1983) highlighted this point by summarising
results from mergers and acquisitions over a period of 11 years. They found that in case of a
merger, the average return, around the date of announcement, to shareholders of the acquired
company is 20 per cent, whereas the average return to the acquiring company is 0 per cent.
Another study by McKinsey indicates that 61 per cent of the 116 acquisitions studied were failures,
23 per cent were successes. Despite such statistics why do companies acquire? Why do mergers
fail? The reasons for merger failures can be numerous. Some of the key reasons are :
• Acquirers generally overpay;
• The value of synergy is over-estimated;
• Poor post-merger integration; and

• Psychological barriers.
Companies often merge in the fear that the bigger competitors have economies of scale and may
destroy them by exercising a stranglehold on raw material supply, distribution etc. What they do
not realise is the drawbacks of being big. The acquiring company’s executives would have drawn
up elaborate plans for the target without consulting its executives wh ich leads to resentment and
managerial attrition. This can be avoided by honest discussions with the target company’s
executives.
Most companies merge with the hope that the benefits of synergy will be realised. Synergy will be
there only if the merged entity is managed better after the acquisition than it was managed before.
It is the quality of the top management that determines the success of the merger. Quite often the
executives of the acquiring company lose interest in the target company due to its smallness. The
small company executives get bogged down repairing vision and mission statements, budgets,
forecasts, profit plans which were hitherto unheard of. The elaborateness of the control system
depends on the size and culture of the company. To make a merger successful,
• Decide what tasks need to be accomplished in the post-merger period;
• Choose managers from both the companies (and from outside);
• Establish performance yardstick and evaluate the managers on that yardstick; and
• Motivate them.
13. ACQUISITION THROUGH SHARES

The acquirer can pay the target company in cash or exchange shares in consideration. The
analysis of acquisition for shares is slightly different. The steps involved in the analysis are:
• Estimate the value of acquirer’s (self) equity;
• Estimate the value of target company’s equity;
• Calculate the maximum number of shares that can be exchanged with the target company’s
shares; and
• Conduct the analysis for pessimistic and optimistic scenarios.
Exchange ratio is the number of acquiring firm’s shares exchanged for each share of the selling
firm’s stock. Suppose company A is trying to acquire company B’s 100,000 shares at ` 230. So
the cost of acquisition is ` 230,00,000. Company A has estimated its value at ` 200 per share. To
get one share of company B, A has to exchange (230/200) 1.15 share, or 115,000 shares for
100,000 shares of B. The relative merits of acquisition for cash or shares should be analysed after
giving due consideration to the impact on EPS, capital structure, etc.
Normally when shares are issued in payment to the selling company’s shareholders, stockholders
will find the merger desirable only if the value of their shares is higher with the merger than without
the merger. The number of shares that the buying company will issue in acquiring the selling
company is determined as follows:
(1) The acquiring company will compare its value per share with and without the merger.
(2) The selling company will compare its value with the value of shares that they would receive
from acquiring company under the merger.
(3) The managements of acquiring company and selling company will negotiate the final terms
of the merger in the light of (1) and (2); the ultimate terms of the merger will reflect the
relative bargaining position of the two companies.
The fewer of acquiring company’s shares that acquiring company must pay to selling company, the
better off are the shareholders of acquiring company and worse off are the shareholders of selling
company. However, for the merger to be effected, the shareholders of both the buying and selling
company will have to anticipate some benefits from the merger even though their share swap deal
is subject to synergy risk for both of them.
Impact of Price Earning Ratio: The reciprocal of cost of equity is Price-Earning (P/E) ratio. The
cost of equity, and consequently the P/E ratio reflects risk as perceived by the shareholders. The
risk of merging entities and the combined business can be different. In other words, the combined
P/E ratio can very well be different from those of the merging entities. Since market value of a
business can be expressed as product of earning and P/E ratio (P/E x E = P), the value of
combined business is a function of combined earning and combined P/E ratio. A lower combined
P/E ratio can offset the gains of synergy or a higher P/E ratio can lead to higher value of business,
even if there is no synergy. In ascertaining the exchange ratio of shares due care should be
exercised to take the possible combined P/E ratio into account.
Illustration 2
Company X is contemplating the purchase of Company Y, Company X has 3,00,000 shares having
a market price of ` 30 per share, while Company Y has 2,00,000 shares selling at ` 20 per share.
The EPS are ` 4.00 and ` 2.25 for Company X and Y respectively. Managements of both
companies are discussing two alternative proposals for exchange of shares as indicated below:
(i) in proportion to the relative earnings per share of two companies.
(ii) 0.5 share of Company X for one share of Company Y (0.5:1).
You are required:
(i) to calculate the Earnings Per share (EPS) after merger under two alternatives; and
(ii) to show the impact of EPS for the shareholders of two companies under both the
alternatives.
Solution
Working Notes: Calculation of total earnings after merger
Particulars Company X Company Y Total
Outstanding shares 3,00,000 2,00,000
EPS (`) 4 2.25
Total earnings (`) 12,00,000 4,50,000 16,50,000
(i) (a) Calculation of EPS when exchange ratio is in proportion to relative EPS of two
companies
Company X 3,00,000
Company Y 2,00,000 x 2.25/4 1,12,500
Total number of shares after merger 4,12,500
Company X
EPS before merger = `4
EPS after merger = ` 16,50,000/4,12,500 shares = `4
Company Y
EPS before merger = ` 2.25
EPS after merger
= EPS of Merged Entity after merger x Share Exchange ratio on
2.25 = ` 2.25
EPS basis = ` 4×
4
(b) Calculation of EPS when share exchange ratio is 0.5 : 1

Total earnings after merger = ` 16,50,000
Total number of shares after merger = 3,00,000 + (2,00,000 x 0.5) = 4,00,000 shares
EPS after merger = ` 16,50,000/4,00,000 = ` 4.125
(ii) Impact of merger on EPS for shareholders of Company X and Company Y
(a) Impact on Shareholders of Company X
(`)
EPS before merger 4.000
EPS after merger 4.125
Increase in EPS 0.125
(b) Impact on Shareholders of Company Y

(`)
Equivalent EPS before merger 2.2500
Equivalent EPS after merger 2.0625
Decrease in EPS 0.1875
Illustration 3
A Ltd. is studying the possible acquisition of B Ltd. by way of merger. The following data are available:
Firm After-tax earnings No. of equity shares Market price per share
A Ltd. ` 10,00,000 2,00,000 ` 75
B Ltd. ` 3,00,000 50,000 ` 60
(i) If the merger goes through by exchange of equity shares and the exchange ratio is set
according to the current market prices, what is the new earnings per share for A Ltd..
(ii) B Ltd. wants to be sure that its earning per share is not diminished by the merger. What
exchange ratio is relevant to achieve the objective?
Solution
(i) The current market price is the basis of exchange of equity shares, in the proposed merger,
shareholders of B Ltd. will get only 40,000 shares in all or 4 shares of A Ltd. for every 5
shares held by them, i.e.,
50,000  60
= 40,000
75
The total number of shares in A Ltd. will then be 2,40,000 and, ignoring any synergistic
effect, the profit will be ` 13,00,000.The new earning per share (EPS) of A Ltd. will be `
5.42, i.e., ` 13,00,000/2,40,000.
(ii) The present earnings per share of B Ltd. is `6/- (` 3,00,000 ÷ 50,000) and that of A Ltd. is
`5/-, i.e., ` 10,00,000 ÷ 2,00,000.If B Ltd. wants to ensure that, even after merger, the
earning per share of its shareholders should remain unaffected, then the exchange ratio will
be 6 shares for every 5 shares.
The total number of shares of A Ltd. that will produce ` 3,00,000 profit is 60,000, (3,00,000
÷ 5), to be distributed among, shareholders of B Ltd., giving a ratio of 6 shares in A for 5
shares in B.
Proof:
The shareholders of B Ltd. will get in all 60,000 share for 50,000 shares. It means after
` 13,00,000
merger, their earning per share will be ` 5/-, i.e. .
2,60,000
In all they will get `3,00,000, i.e., 60,000 x 5, as before.
Illustration 4
Simpson Ltd. is considering a merger with Wilson Ltd. The data below are in the hands of both
Board of Directors. The issue at hand is how many shares of Simpson should be exchanged for
Wilson Ltd. Both boards are considering three possibilities 20,000, 25,000 and 30,000 shares. You
are required to construct a table demonstrating the potential impact of each scheme on each set of
shareholders:
Simpson Wilson Combined
Ltd. Ltd. Post merger
Firm ‘A’
1. Current earnings per year 2,00,000 1,00,000 3,50,000
2. Shares outstanding 50,000 10,000 ?
3. Earnings per share (`) (1÷ 2) 4 10 ?
4. Price per share (`) 40 100 ?
5. Price-earning ratio [4  3] 10 10 10
6. Value of firm (`) 20,00,000 10,00,000 35,00,000
7. Expected Annual growth rate in
earnings in foreseeable future 0 0 0
Solution
The following table demonstrates the potential impact of the three possible schemes, on each set of
shareholders:-
Number Exchange Number of Fraction of Value of Fraction of Value of
of ratio Simpson Simpson shares Simpson shares
Simpson [(1)/10,000 Ltd.’s Ltd. (Post owned by Ltd. owned by
Ltd.’s shares of shares merger) Wilson (combined Simpson
shares Wilson Ltd.] outstanding owned by Ltd.’s Post- Ltd.’s
issued to after merger Wilson shareholders merger shareholders
sharehol [50,000+(1)] Ltd.’s [(4)x owned by [(6) x
ders of shareholder 35,00,000] Simpson 35,00,000]
Wilson s [(1)/(3)] Ltd.’s
Ltd. share-
holders
[50,000/(3)]
(1) (2) (3) (4) (5) (6) (7)
20,000 2 70,000 2/7 10,00,000 5/7 25,00,000
25,000 2.5 75,000 1/3 11,66,667 2/3 23,33,333
30,000 3 80,000 3/8 13,12,500 5/8 21,87,500
14. CROSS-BORDER M&A

Cross-border M&A is a popular route for global growth and overseas expansion. Cross-border
M&A is also playing an important role in global M&A. This is especially true for developing
countries such as India. Kaushik Chatterjee, CFO, of Tata Steel in an interview with McKenzie
Quarterly in September 2009 articulates this point very clearly. To the following question
The Quarterly: Last year was the first in which Asian and Indian companies acquired more
businesses outside of Asia than European or US multinationals acquired within it. What’s behind
the Tata Group’s move to go global?
His respons is as follows:-
“India is clearly a very large country with a significant population and a big market, and the Ta ta
Group’s companies in a number of sectors have a pretty significant market share. India remains
the main base for future growth for Tata Steel Group, and we have substantial investment plans in
India, which are currently being pursued but meeting our growth goals through organic means in
India, unfortunately, is not the fastest approach, especially for large capital projects, due to
significant delays on various fronts. Nor are there many opportunities for growth through
acquisitions in India, particularly in sectors like steel, where the value to be captured is limited—for
example, in terms of technology, product profiles, the product mix, and good management.”
Other major factors that motivate multinational companies to engage in cross -border M&A in Asia
include the following:
• Globalization of production and distribution of products and services.
• Integration of global economies.
• Expansion of trade and investment relationships on International level.
• Many countries are reforming their economic and legal systems, and providing generous
investment and tax incentives to attract foreign investment.
• Privatisation of state-owned enterprises and consolidation of the banking industry.
TEST YOUR KNOWLEDGE

1. Explain synergy in the context of Mergers and Acquisitions.
2. What is take over by reverse bid or Reverse Merger.
3. What is an equity curve out? How does it differ from a spin off.
4. Write a short note on Horizontal Merger and Vertical Merger.
Practical Questions
1. B Ltd. is a highly successful company and wishes to expand by acquiring other firms. Its
expected high growth in earnings and dividends is reflected in its PE ratio of 17. The Board
of Directors of B Ltd. has been advised that if it were to take over firms with a lower PE ratio
than it own, using a share-for-share exchange, then it could increase its reported earnings
per share. C Ltd. has been suggested as a possible target for a takeover, which has a PE
ratio of 10 and 1,00,000 shares in issue with a share price of ` 15. B Ltd. has 5,00,000
shares in issue with a share price of ` 12.
Calculate the change in earnings per share of B Ltd. if it acquires the whole of C Ltd. by
issuing shares at its market price of `12. Assume the price of B Ltd. shares remains
constant.
2. Elrond Limited plans to acquire Doom Limited. The relevant financial details of the two
firms prior to the merger announcement are:
Elrond Limited Doom Limited
Market price per share ` 50 ` 25
Number of outstanding shares 20 lakhs 10 Lakhs
The merger is expected to generate gains, which have a present value of `200 lakhs. The
exchange ratio agreed to is 0.5.
What is the true cost of the merger from the point of view of Elrond Limited?
3. MK Ltd. is considering acquiring NN Ltd. The following information is available:
Company Earning after No. of Equity Market Value
Tax (`) Shares Per Share (`)
MK Ltd. 60,00,000 12,00,000 200.00
NN Ltd. 18,00,000 3,00,000 160.00
Exchange of equity shares for acquisition is based on current market value as above . There
is no synergy advantage available.
(i) Find the earning per share for company MK Ltd. after merger, and
(ii) Find the exchange ratio so that shareholders of NN Ltd. would not be at a loss.
4. ABC Ltd. is intending to acquire XYZ Ltd. by merger and the following information is
available in respect of the companies:
ABC Ltd. XYZ Ltd.
Number of equity shares 10,00,000 6,00,000
Earnings after tax (`) 50,00,000 18,00,000
Market value per share (`) 42 28
Required:
(i) What is the present EPS of both the companies?
(ii) If the proposed merger takes place, what would be the new earning per share for
ABC Ltd.? Assume that the merger takes place by exchange of equity shares and
the exchange ratio is based on the current market price.
(iii) What should be exchange ratio, if XYZ Ltd. wants to ensure the earnings to
members are same as before the merger takes place?
5. The CEO of a company thinks that shareholders always look for EPS. Therefore, he
considers maximization of EPS as his company's objective. His company's current Net
Profits are ` 80.00 lakhs and P/E multiple is 10.5. He wants to buy another firm which has
current income of ` 15.75 lakhs & P/E multiple of 10.
What is the maximum exchange ratio which the CEO should offer so that he could keep
EPS at the current level, given that the current market price of both the acquirer and the
target company are ` 42 and ` 105 respectively?
If the CEO borrows funds at 15% and buys out Target Company by paying cash, how much
cash should he offer to maintain his EPS? Assume tax rate of 30%.
6. A Ltd. wants to acquire T Ltd. and has offered a swap ratio of 1:2 (0.5 shares for every one
share of T Ltd.). Following information is provided:
A Ltd. T. Ltd.
Profit after tax `18,00,000 `3,60,000
Equity shares outstanding (Nos.) 6,00,000 1,80,000
EPS `3 `2
PE Ratio 10 times 7 times
Market price per share `30 `14
Required:
(i) The number of equity shares to be issued by A Ltd. for acquisition of T Ltd.
(ii) What is the EPS of A Ltd. after the acquisition?
(iii) Determine the equivalent earnings per share of T Ltd.
(iv) What is the expected market price per share of A Ltd. after the acquisition, assuming
its PE multiple remains unchanged?
(v) Determine the market value of the merged firm.
7. The following information is provided related to the acquiring Firm Mark Limited and the
target Firm Mask Limited:
Firm Firm
Mark Limited Mask Limited
Earning after tax (`) 2,000 lakhs 400 lakhs
Number of shares outstanding 200 lakhs 100 lakhs
P/E ratio (times) 10 5
Required:
(i) What is the Swap Ratio based on current market prices?
(ii) What is the EPS of Mark Limited after acquisition?
(iii) What is the expected market price per share of Mark Limited after acquisition,
assuming P/E ratio of Mark Limited remains unchanged?
(iv) Determine the market value of the merged firm.
(v) Calculate gain/loss for shareholders of the two independent companies after
acquisition.
8. XYZ Ltd. wants to purchase ABC Ltd. by exchanging 0.7 of its share for each share of ABC
Ltd. Relevant financial data are as follows:
Equity shares outstanding 10,00,000 4,00,000
EPS (`) 40 28
Market price per share (`) 250 160
(i) Illustrate the impact of merger on EPS of both the companies.

(ii) The management of ABC Ltd. has quoted a share exchange ratio of 1:1 for the
merger. Assuming that P/E ratio of XYZ Ltd. will remain unchanged after the merger,
what will be the gain from merger for ABC Ltd.?
(iii) What will be the gain/loss to shareholders of XYZ Ltd.?
(iv) Determine the maximum exchange ratio acceptable to shareholders of XYZ Ltd.
9. XYZ Ltd., is considering merger with ABC Ltd. XYZ Ltd.’s shares are currently traded at
` 20. It has 2,50,000 shares outstanding and its earnings after taxes (EAT) amount to
` 5,00,000. ABC Ltd., has 1,25,000 shares outstanding; its current market price is ` 10 and
its EAT are ` 1,25,000. The merger will be effected by means of a stock swap (exchange).
ABC Ltd., has agreed to a plan under which XYZ Ltd., will offer the current market value of
ABC Ltd.’s shares:
(i) What is the pre-merger earnings per share (EPS) and P/E ratios of both the
companies?
(ii) If ABC Ltd.’s P/E ratio is 6.4, what is its current market price? What is the exchange
ratio? What will XYZ Ltd.’s post-merger EPS be?
(iii) What should be the exchange ratio; if XYZ Ltd.’s pre-merger and post-merger EPS
are to be the same?
10. Following information is provided relating to the acquiring company Mani Ltd. and the target
company Ratnam Ltd:
Mani Ltd. Ratnam Ltd.
Earnings after tax (` lakhs) 2,000 4,000
No. of shares outstanding (lakhs) 200 1,000
P/E ratio (No. of times) 10 5
Required:
(i) What is the swap ratio based on current market prices?
(ii) What is the EPS of Mani Ltd. after the acquisition?
(iii) What is the expected market price per share of Mani Ltd. after the acquisition,
assuming its P/E ratio is adversely affected by 10%?
(iv) Determine the market value of the merged Co.
(v) Calculate gain/loss for the shareholders of the two independent entities, due to the
merger.
11. You have been provided the following Financial data of two companies:
Krishna Ltd. Rama Ltd.

Earnings after taxes ` 7,00,000 ` 10,00,000
No. of Equity shares (outstanding) 2,00,000 4,00,000
EPS 3.5 2.5
P/E ratio 10 times 14 times
Company Rama Ltd. is acquiring the company Krishna Ltd., exchanging its shares on a
one-to-one basis for company Krishna Ltd. The exchange ratio is based on the market
prices of the shares of the two companies.
Required:
(i) What will be the EPS subsequent to merger?
(ii) What is the change in EPS for the shareholders of companies Rama Ltd. and
Krishna Ltd.?
(iii) Determine the market value of the post-merger firm. PE ratio is likely to remain the
same.
(iv) Ascertain the profits accruing to shareholders of both the companies.
12. M Co. Ltd. is studying the possible acquisition of N Co. Ltd., by way of merger. The
following data are available in respect of the companies:
Particulars M Co. Ltd. N Co. Ltd.
Earnings after tax (`) 80,00,000 24,00,000
No. of equity shares 16,00,000 4,00,000
Market value per share (`) 200 160
(i) If the merger goes through by exchange of equity and the exchange ratio is based on
the current market price, what is the new earning per share for M Co. Ltd.?
(ii) N Co. Ltd. wants to be sure that the earnings available to its shareholders will not be
diminished by the merger. What should be the exchange ratio in that case?
13. Longitude Limited is in the process of acquiring Latitude Limited on a share exchange
basis. Following relevant data are available:
Longitude Latitude
Limited Limited
Profit after Tax (PAT) ` in Lakhs 120 80
Number of Shares Lakhs 15 16
Earning per Share (EPS) ` 8 5
Price Earnings Ratio (P/E Ratio) 15 10
(Ignore Synergy)

(i) Pre-merger Market Value per Share, and
(ii) The maximum exchange ratio Longitude Limited can offer without the dilution of
(1) EPS and
(2) Market Value per Share
Calculate Ratio/s up to four decimal points and amounts and number o f shares up to two
decimal points.
14. P Ltd. is considering take-over of R Ltd. by the exchange of four new shares in P Ltd. for
every five shares in R Ltd. The relevant financial details of the two companies prior to
merger announcement are as follows:
P Ltd R Ltd
Profit before Tax (` Crore) 15 13.50
No. of Shares (Crore) 25 15
P/E Ratio 12 9
Corporate Tax Rate 30%
(i) Market value of both the company.
(ii) Value of original shareholders.
(iii) Price per share after merger.
(iv) Effect on share price of both the company if the Directors of P Ltd. expect their own
pre-merger P/E ratio to be applied to the combined earnings.
15. Simple Ltd. and Dimple Ltd. are planning to merge. The total value of the companies are
dependent on the fluctuating business conditions. The following information is given for the
total value (debt + equity) structure of each of the two companies.
Business Condition Probability Simple Ltd. ` Lacs Dimple Ltd. ` Lacs
High Growth 0.20 820 1050
Medium Growth 0.60 550 825
Slow Growth 0.20 410 590
The current debt of Dimple Ltd. is ` 65 lacs and of Simple Ltd. is ` 460 lacs.
Calculate the expected value of debt and equity separately for the merged entity.
16. Yes Ltd. wants to acquire No Ltd. and the cash flows of Yes Ltd. and the merged entity are
given below:
(` In lakhs)
Year 1 2 3 4 5
Yes Ltd. 175 200 320 340 350
Merged Entity 400 450 525 590 620
Earnings would have witnessed 5% constant growth rate without merger and 6% with
merger on account of economies of operations after 5 years in each case. The cost of
capital is 15%.
The number of shares outstanding in both the companies before the merger is the same
and the companies agree to an exchange ratio of 0.5 shares of Yes Ltd. for each share of
No Ltd.
PV factor at 15% for years 1-5 are 0.870, 0.756; 0.658, 0.572, 0.497 respectively.
(i) Compute the Value of Yes Ltd. before and after merger.
(ii) Value of Acquisition and
(iii) Gain to shareholders of Yes Ltd.
17. The following information is provided relating to the acquiring company Effici ent Ltd. and
the target Company Healthy Ltd.
Efficient Ltd. Healthy Ltd.

No. of shares (F.V. ` 10 each) 10.00 lakhs 7.5 lakhs
Market capitalization 500.00 lakhs 750.00 lakhs
P/E ratio (times) 10.00 5.00
Reserves and Surplus 300.00 lakhs 165.00 lakhs
Promoter’s Holding (No. of shares) 4.75 lakhs 5.00 lakhs
Board of Directors of both the Companies have decided to give a fair deal to the
shareholders and accordingly for swap ratio the weights are decided as 40%, 25% and 35%
respectively for Earning, Book Value and Market Price of share of each company:
(i) Calculate the swap ratio and also calculate Promoter’s holding % after acquisition.
(ii) What is the EPS of Efficient Ltd. after acquisition of Healthy Ltd.?
(iii) What is the expected market price per share and market capitalization of Efficient
Ltd. after acquisition, assuming P/E ratio of Firm Efficient Ltd. remains unchanged.
(iv) Calculate free float market capitalization of the merged firm.
18. Abhiman Ltd. is a subsidiary of Janam Ltd. and is acquiring Swabhiman Ltd. which is also a
subsidiary of Janam Ltd. The following information is given :
Abhiman Ltd. Swabhiman Ltd.

% Shareholding of promoter 50% 60%
Share capital ` 200 lacs 100 lacs
Free Reserves and surplus ` 900 lacs 600 lacs
Paid up value per share ` 100 10
Free float market capitalization ` 500 lacs 156 lacs
P/E Ratio (times) 10 4
Janam Ltd., is interested in doing justice to both companies. The following parameters have
been assigned by the Board of Janam Ltd., for determining the swap ratio:
Book value 25%
Earning per share 50%
Market price 25%
You are required to compute
(i) The swap ratio.
(ii) The Book Value, Earning Per Share and Expected Market Price of Swabhiman Ltd.,
(assuming P/E Ratio of Abhiman remains the same and all assets and liabilities of
Swabhiman Ltd. are taken over at book value.)
19. The following information is provided relating to the acquiring company E Ltd., and the
target company H Ltd:
E Ltd. H Ltd.
Particulars
(`) (`)
Number of shares (Face value ` 10 each) 20 Lakhs 15 Lakhs
Market Capitalization 1000 Lakhs 1500 Lakhs
P/E Ratio (times) 10.00 5.00
Reserves and surplus in ` 600.00 Lakhs 330.00 Lakhs
Promoter's Holding (No. of shares) 9.50 Lakhs 10.00 Lakhs
The Board of Directors of both the companies have decided to give a fair deal to the
shareholders. Accordingly, the weights are decided as 40%, 25% and 35% respectively for
earnings, book value and market price of share of each company for swap ratio.
Calculate the following:
(i) Market price per share, earnings per share and Book Value per share;
(ii) Swap ratio;

(iii) Promoter's holding percentage after acquisition;
(iv) EPS of E Ltd. after acquisitions of H Ltd;
(v) Expected market price per share and market capitalization of E Ltd.; after
acquisition, assuming P/E ratio of E Ltd. remains unchanged; and
(vi) Free float market capitalization of the merged firm.
20. The following information relating to the acquiring Company Abhiman Ltd. and the target
Company Abhishek Ltd. are available. Both the Companies are promoted by Multinational
Company, Trident Ltd. The promoter’s holding is 50% and 60% respectively in Abhiman Ltd.
and Abhishek Ltd.:
Abhiman Ltd. Abhishek Ltd.

Share Capital (`) 200 lakh 100 lakh
Free Reserve and Surplus (`) 800 lakh 500 lakh
Paid up Value per share (`) 100 10
Free float Market Capitalisation (`) 400 lakh 128 lakh
Trident Ltd. is interested to do justice to the shareholders of both the Companies. For the
swap ratio weights are assigned to different parameters by the Board of Directors as
follows:
Book Value 25%
EPS (Earning per share) 50%
Market Price 25%
(a) What is the swap ratio based on above weights?
(b) What is the Book Value, EPS and expected Market price of Abhiman Ltd. after
acquisition of Abhishek Ltd. (assuming P.E. ratio of Abhiman Ltd. remains
unchanged and all assets and liabilities of Abhishek Ltd. are taken over at book
value).
(c) Calculate:
(i) Promoter’s revised holding in the Abhiman Ltd.
(ii) Free float market capitalization.
(iii) Also calculate No. of Shares, Earning per Share (EPS) and Book Value (B.V.),
if after acquisition of Abhishek Ltd., Abhiman Ltd. decided to :
(1) Issue Bonus shares in the ratio of 1 : 2; and

(2) Split the stock (share) as ` 5 each fully paid.
21. T Ltd. and E Ltd. are in the same industry. The former is in negotiation for acquisition of the
latter. Important information about the two companies as per their latest financial
statements is given below:
T Ltd. E Ltd.
` 10 Equity shares outstanding 12 Lakhs 6 Lakhs
Debt:
10% Debentures (` Lakhs) 580 --
12.5% Institutional Loan (` Lakhs) -- 240
Earning before interest, depreciation and tax (EBIDAT) 400.86 115.71
(` Lakhs)
Market Price/share (`) 220.00 110.00
T Ltd. plans to offer a price for E Ltd., business as a whole which will be 7 times EBIDAT
reduced by outstanding debt, to be discharged by own shares at market price.
E Ltd. is planning to seek one share in T Ltd. for every 2 shares in E Ltd. based on the
market price. Tax rate for the two companies may be assumed as 30%.
Calculate and show the following under both alternatives - T Ltd.'s offer and E Ltd.'s plan:
(i) Net consideration payable.
(ii) No. of shares to be issued by T Ltd.
(iii) EPS of T Ltd. after acquisition.
(iv) Expected market price per share of T Ltd. after acquisition.
(v) State briefly the advantages to T Ltd. from the acquisition.
Note: Calculations (except EPS) may be rounded off to 2 decimals in lakhs.
22. The following information is relating to Fortune India Ltd. having two division, viz. Pharma
Division and Fast Moving Consumer Goods Division (FMCG Division). Paid up share capital
of Fortune India Ltd. is consisting of 3,000 Lakhs equity shares of Re. 1 each. Fortune India
Ltd. decided to de-merge Pharma Division as Fortune Pharma Ltd. w.e.f. 1.4.2009. Details
of Fortune India Ltd. as on 31.3.2009 and of Fortune Pharma Ltd. as on 1.4.2009 are given
below:
Particulars Fortune Pharma Ltd. Fortune India Ltd.

` `
Outside Liabilities
Secured Loans 400 lakh 3,000 lakh
Unsecured Loans 2,400 lakh 800 lakh
Current Liabilities & Provisions 1,300 lakh 21,200 lakh
Assets
Fixed Assets 7,740 lakh 20,400 lakh
Investments 7,600 lakh 12,300 lakh
Current Assets 8,800 lakh 30,200 lakh
Loans & Advances 900 lakh 7,300 lakh
Deferred tax/Misc. Expenses 60 lakh (200) lakh
Board of Directors of the Company have decided to issue necessary equity shares of
Fortune Pharma Ltd. of Re. 1 each, without any consideration to the shareholders of
Fortune India Ltd. For that purpose following points are to be considered:
(a) Transfer of Liabilities & Assets at Book value.
(b) Estimated Profit for the year 2009-10 is ` 11,400 Lakh for Fortune India Ltd. & `
1,470 lakhs for Fortune Pharma Ltd.
(c) Estimated Market Price of Fortune Pharma Ltd. is ` 24.50 per share.
(d) Average P/E Ratio of FMCG sector is 42 & Pharma sector is 25, which is to be
expected for both the companies.
Calculate:
1. The Ratio in which shares of Fortune Pharma are to be issued to the shareholders of
Fortune India Ltd.
2. Expected Market price of Fortune India (FMCG) Ltd.
3. Book Value per share of both the Companies immediately after Demerger .
23. H Ltd. agrees to buy over the business of B Ltd. effective 1st April, 2012.The summarized
Balance Sheets of H Ltd. and B Ltd. as on 31 st March 2012 are as follows:
Balance sheet as at 31 st March, 2012 (In Crores of Rupees)
Liabilities: H. Ltd B. Ltd.

Paid up Share Capital
Reserve & Surplus 950.00 25.00
Total 1,300.00 31.50
Assets:
Net Fixed Assets 220.00 0.50
Net Current Assets 1,020.00 29.00
Deferred Tax Assets 60.00 2.00
Total 1,300.00 31.50
H Ltd. proposes to buy out B Ltd. and the following information is provided to you as part of
the scheme of buying:
(a) The weighted average post tax maintainable profits of H Ltd. and B Ltd. for the last 4
years are ` 300 crores and ` 10 crores respectively.
(b) Both the companies envisage a capitalization rate of 8%.
(c) H Ltd. has a contingent liability of ` 300 crores as on 31 st March, 2012.
(d) H Ltd. to issue shares of ` 100 each to the shareholders of B Ltd. in terms of the
exchange ratio as arrived on a Fair Value basis. (Please consider weights of 1 and 3
for the value of shares arrived on Net Asset basis and Earnings capitalization
method respectively for both H Ltd. and B Ltd.)
You are required to arrive at the value of the shares of both H Ltd. and B Ltd. under:
(i) Net Asset Value Method
(ii) Earnings Capitalisation Method
(iii) Exchange ratio of shares of H Ltd. to be issued to the shareholders of B Ltd. on a
Fair value basis (taking into consideration the assumption mentioned in point 4
above.)
24. Reliable Industries Ltd. (RIL) is considering a takeover of Sunflower Industries Ltd. (SIL).
The particulars of 2 companies are given below:
Particulars Reliable Industries Ltd Sunflower Industries Ltd.

Earnings After Tax (EAT) ` 20,00,000 ` 10,00,000
Equity shares O/s 10,00,000 10,00,000
Earnings per share (EPS) 2 1
PE Ratio (Times) 10 5
Required:
(i) What is the market value of each Company before merger?
(ii) Assume that the management of RIL estimates that the shareholders of SIL will
accept an offer of one share of RIL for four shares of SIL. If there are no synergic
effects, what is the market value of the Post-merger RIL? What is the new price per
share? Are the shareholders of RIL better or worse off than they were before the
merger?
(iii) Due to synergic effects, the management of RIL estimates that the earnings will
increase by 20%. What are the new post-merger EPS and Price per share? Will the
shareholders be better off or worse off than before the merger?
25. AFC Ltd. wishes to acquire BCD Ltd. The shares issued by the two companies are
10,00,000 and 5,00,000 respectively:
(i) Calculate the increase in the total value of BCD Ltd. resulting from the acquisition on
the basis of the following conditions:
Current expected growth rate of BCD Ltd. 7%
Expected growth rate under control of AFC Ltd., (without any 8%
additional capital investment and without any change in risk of
operations)
Current Market price per share of AFC Ltd. ` 100
Current Market price per share of BCD Ltd. ` 20
Expected Dividend per share of BCD Ltd. ` 0.60
(ii) On the basis of aforesaid conditions calculate the gain or loss to shareholders of
both the companies, if AFC Ltd. were to offer one of its shares for every four shares
of BCD Ltd.
(iii) Calculate the gain to the shareholders of both the Companies, if AFC Ltd. pays `22
for each share of BCD Ltd., assuming the P/E Ratio of AFC Ltd. does not change
after the merger. EPS of AFC Ltd. is `8 and that of BCD is `2.50. It is assumed that
AFC Ltd. invests its cash to earn 10%.
26. AB Ltd., is planning to acquire and absorb the running business of XY Ltd. The valuation is
to be based on the recommendation of merchant bankers and the consideration is to be
discharged in the form of equity shares to be issued by AB Ltd. As on 31.3.2006, the paid
up capital of AB Ltd. consists of 80 lakhs shares of `10 each. The highest and the lowest
market quotation during the last 6 months were `570 and `430. For the purpose of the
exchange, the price per share is to be reckoned as the average of the h ighest and lowest
market price during the last 6 months ended on 31.3.06.
XY Ltd.’s Balance Sheet as at 31.3.2006 is summarised below:
` lakhs
Sources
Share Capital
20 lakhs equity shares of `10 each fully paid 200
10 lakhs equity shares of `10 each, `5 paid 50
Loans 100
Total 350
Uses
Fixed Assets (Net) 150
Net Current Assets 200
350
An independent firm of merchant bankers engaged for the negotiation, have produced the
following estimates of cash flows from the business of XY Ltd.:
Year ended By way of ` lakhs
31.3.07 after tax earnings for equity 105
31.3.08 do 120
31.3.09 Do 125
31.3.10 Do 120
31.3.11 Do 100
Terminal Value estimate 200
It is the recommendation of the merchant banker that the business of XY Ltd. may be
valued on the basis of the average of (i) Aggregate of discounted cash flows at 8% and (ii)
Net assets value. Present value factors at 8% for years
1-5: 0.93 0.86 0.79 0.74 0.68
(a) Calculate the total value of the business of XY Ltd.
(b) The number of shares to be issued by AB Ltd.; and
(c) The basis of allocation of the shares among the shareholders of XY Ltd.
27. R Ltd. and S Ltd. are companies that operate in the same industry. The financial statements
of both the companies for the current financial year are as follows:
Balance Sheet
Particulars R. Ltd. (` ) S. Ltd (` )
Equity & Liabilities
Shareholders Fund
Equity Capital (` 10 each) 20,00,000 16,00,000
Retained earnings 4,00,000 -
Non-current Liabilities
16% Long term Debt 10,00,000 6,00,000
Current Liabilities 14,00,000 8,00,000
Total 48,00,000 30,00,000
Assets
Non-current Assets 20,00,000 10,00,000
Current Assets 28,00,000 20,00,000
Total 48,00,000 30,00,000
Income Statement
Particulars R. Ltd. (`) S. Ltd. (`)
A. Net Sales 69,00,000 34,00,000
B. Cost of Goods sold 55,20,000 27,20,000
C. Gross Profit (A-B) 13,80,000 6,80,00
D. Operating Expenses 4,00,000 2,00,000
E. Interest 1,60,000 96,000
F. Earnings before taxes [C-(D+E)] 8,20,000 3,84,000
G. Taxes @ 35% 2,87,000 1,34,400
H. Earnings After Tax (EAT) 5,33,000 2,49,600
Additional Information:
No. of equity shares 2,00,000 1,60,000
Dividend payment Ratio (D/P) 20% 30%
Assume that both companies are in the process of negotiating a merger through exchange
of Equity shares:

(i) Decompose the share price of both the companies into EPS & P/E components. Also
segregate their EPS figures into Return On Equity (ROE) and Book Value/Intrinsic
Value per share components.
(ii) Estimate future EPS growth rates for both the companies.
(iii) Based on expected operating synergies, R Ltd. estimated that the intrinsic value of S
Ltd. Equity share would be ` 25 per share on its acquisition. You are required to
develop a range of justifiable Equity Share Exchange ratios that can be offered by R
Ltd. to the shareholders of S Ltd. Based on your analysis on parts (i) and (ii), would
you expect the negotiated terms to be closer to the upper or the lower exchange
ratio limits and why?
28. BA Ltd. and DA Ltd. both the companies operate in the same industry. The Financial
statements of both the companies for the current financial year are as follows:
Balance Sheet
Particulars BA Ltd.(`) DA Ltd.(`)
Current Assets 14,00,000 10,00,000
Fixed Assets (Net) 10,00,000 5,00,000
Total (`) 24,00,000 15,00,000
Equity capital (`10 each) 10,00,000 8,00,000
Retained earnings 2,00,000 --
14% long-term debt 5,00,000 3,00,00
Current liabilities 7,00,000 4,00,000
Total (`) 24,00,000 15,00,000
Income Statement
BA Ltd. DA Ltd.
(`) (`)
Net Sales 34,50,000 17,00,000
Cost of Goods sold 27,60,000 13,60,000
Gross profit 6,90,000 3,40,000
Operating expenses 2,00,000 1,00,000
Interest 70,000 42,000
Earnings before taxes 4,20,000 1,98,00
Taxes @ 50% 2,10,000 99,000
Earnings after taxes (EAT) 2,10,000 99,000
Additional Information :
No. of Equity shares 1,00,000 80,000
Dividend payment ratio (D/P) 40% 60%
Market price per share `40 `15
Assume that both companies are in the process of negotiating a merger through an
exchange of equity shares. You have been asked to assist in establishing equitable
exchange terms and are required to:
(i) Decompose the share price of both the companies into EPS and P/E components;
and also segregate their EPS figures into Return on Equity (ROE) and book
value/intrinsic value per share components.
(ii) Estimate future EPS growth rates for each company.
(iii) Based on expected operating synergies BA Ltd. estimates that the intrinsic value of
DA’s equity share would be `20 per share on its acquisition. You are required to
develop a range of justifiable equity share exchange ratios that can be offered by BA
Ltd. to the shareholders of DA Ltd. Based on your analysis in part (i) and (ii), would
you expect the negotiated terms to be closer to the upper, or the lower exchange
ratio limits and why?
(iv) Calculate the post-merger EPS based on an exchange ratio of 0.4: 1 being offered
by BA Ltd. and indicate the immediate EPS accretion or dilution, if any, that will
occur for each group of shareholders.
(v) Based on a 0.4: 1 exchange ratio and assuming that BA Ltd.’s pre-merger P/E ratio
will continue after the merger, estimate the post-merger market price. Also show the
resulting accretion or dilution in pre-merger market prices.
29. During the audit of the Weak Bank (W), RBI has suggested that the Bank should either
merge with another bank or may close down. Strong Bank (S) has submitted a proposal of
merger of Weak Bank with itself. The relevant information and Balance Sheets of both the
companies are as under:
Particulars Weak Bank Strong Assigned
(W) Bank (S) Weights (%)
Gross NPA (%) 40 5 30
Capital Adequacy Ratio (CAR) 5 16 28
Total Capital/ Risk Weight Asset
Market price per Share (MPS) 12 96 32
Book value 10
Trading on Stock Exchange Irregular Frequent
Balance Sheet (` in Lakhs)

Particulars Weak Bank (W) Strong Bank (S)
Paid up Share Capital (` 10 per share) 150 500
Reserves & Surplus 80 5,500
Deposits 4,000 44,000
Other Liabilities 890 2,500
Total Liabilities 5,120 52,500
Cash in Hand & with RBI 400 2,500
Balance with Other Banks - 2,000
Investments 1,100 19,000
Advances 3,500 27,000
Other Assets 70 2,000
Preliminary Expenses 50 -
Total Assets 5,120 52,500
You are required to

(a) Calculate Swap ratio based on the above weights:
(b) Ascertain the number of Shares to be issued to Weak Bank;
(c) Prepare Balance Sheet after merger; and
(d) Calculate CAR and Gross NPA of Strong Bank after merger.
30. M/s Tiger Ltd. wants to acquire M/s. Leopard Ltd. The balance sheet of Leopard Ltd. as on
31st March, 2012 is as follows:
Liabilities ` Assets `
Equity Capital (70,000 shares) Cash 50,000
Retained earnings 3,00,000 Debtors 70,000
12% Debentures 3,00,000 Inventories 2,00,000
Creditors and other liabilities 3,20,000 Plants & Eqpt. 13,00,000
16,20,000 16,20,000
Additional Information:
(i) Shareholders of Leopard Ltd. will get one share in Tiger Ltd. for every two shares.
External liabilities are expected to be settled at ` 5,00,000. Shares of Tiger Ltd.
would be issued at its current price of ` 15 per share. Debenture holders will get
13% convertible debentures in the purchasing company for the same amount.
Debtors and inventories are expected to realize ` 2,00,000.
(ii) Tiger Ltd. has decided to operate the business of Leopard Ltd. as a separate
division. The division is likely to give cash flows (after tax) to the extent of ` 5,00,000
per year for 6 years. Tiger Ltd. has planned that, after 6 years, this division would be
demerged and disposed of for ` 2,00,000.
(iii) The company’s cost of capital is 16%.
Make a report to the Board of the company advising them about the financial feasibility of
this acquisition.
Net present values for 16% for ` 1 are as follows:
Years 1 2 3 4 5 6
PV 0.862 0.743 0.641 0.552 0.476 0.410
31. The equity shares of XYZ Ltd. are currently being traded at ` 24 per share in the market.
XYZ Ltd. has total 10,00,000 equity shares outstanding in number; and promoters' equity
holding in the company is 40%.
PQR Ltd. wishes to acquire XYZ Ltd. because of likely synergies. The estimated present
value of these synergies is ` 80,00,000.
Further PQR feels that management of XYZ Ltd. has been over paid. With better motivation,
lower salaries and fewer perks for the top management, will lead to savings of ` 4,00,000
p.a. Top management with their families are promoters of XYZ Ltd. Present value of these
savings would add ` 30,00,000 in value to the acquisition.
Following additional information is available regarding PQR Ltd.:
Earnings per share :`4
Total number of equity shares outstanding : 15,00,000
Market price of equity share : ` 40
Required:
(i) What is the maximum price per equity share which PQR Ltd. can offer to pay for XYZ
Ltd.?
(ii) What is the minimum price per equity share at which the management of XYZ Ltd.
will be willing to offer their controlling interest?
ANSWERS/ SOLUTIONS

1. Total market value of C Ltd is = 1,00,000 x ` 15 = ` 15,00,000
PE ratio (given) = 10
Therefore, earnings = ` 15,00,000 /10
= ` 1,50,000
Total market value of B Ltd. is = 5,00,000 x ` 12 = ` 60,00,000
PE ratio (given) = 17
Therefore, earnings = ` 60,00,000/17
= ` 3,52,941
The number of shares to be issued by B Ltd.
` 15,00,000 ÷ 12 = 1,25,000
Total number of shares of B Ltd = 5,00,000 + 1,25,000 = 6,25,000
The EPS of the new firm is = (` 3,52,941+`1,50,000)/6,25,000

= ` 0.80
The present EPS of B Ltd is = ` 3,52,941 /5,00,000
= ` 0.71
So the EPS affirm B will increase from Re. 0.71 to ` 0.80 as a result of merger
2. Shareholders of Doom Ltd. will get 5 lakh share of Elrond Limited, so they will get:
5 lakh
= = 20% of shares Elrond Limited
20 lakh + 5 lakh
The value of Elrond Ltd. after merger will be:
= ` 50 x 20 lakh + ` 25 x 10 lakh + ` 200 lakh
= ` 1000 lakh + ` 250 lakh + ` 200 lakh = ` 1450 lakh
True Cost of Merger will be:
(` 1450 x 20%) ` 290 lakhs – ` 250 lakhs = ` 40 lakhs
3. (i) Earning per share of company MK Ltd after merger:-

Exchange ratio 160 : 200 = 4 : 5.
that is 4 shares of MK Ltd. for every 5 shares of NN Ltd.
Total number of shares to be issued = 4/5  3,00,000 = 2,40,000 Shares.
Total number of shares of MK Ltd. and NN Ltd.=12,00,000 (MK Ltd.)+2,40,000 (NN Ltd.)
= 14,40,000 Shares
Total profit after tax = ` 60,00,000 MK Ltd.
= ` 18,00,000 NN Ltd.
= ` 78,00,000
 EPS. (Earning Per Share) of MK Ltd. after merger
` 78,00,000/14,40,000 = ` 5.42 per share
(ii) To find the exchange ratio so that shareholders of NN Ltd. would not be at a Loss:
Present earning per share for company MK Ltd.
= ` 60,00,000/12,00,000 = ` 5.00
Present earning per share for company NN Ltd.
= ` 18,00,000/3,00,000 = ` 6.00
 Exchange ratio should be 6 shares of MK Ltd. for every 5 shares of NN Ltd.
 Shares to be issued to NN Ltd. = 3,00,000  6/5 = 3,60,000 shares
Now, total No. of shares of MK Ltd. and NN Ltd. =12,00,000 (MK Ltd.) + 3,60,000
(NN Ltd.)
= 15,60,000 shares
 EPS after merger = ` 78,00,000/15,60,000 = ` 5.00 per share
Total earnings available to shareholders of NN Ltd. after merger = 3,60,000 shares 
` 5.00 = ` 18,00,000.
This is equal to earnings prior merger for NN Ltd.
 Exchange ratio on the basis of earnings per share is recommended.
4. (i) Earnings per share = Earnings after tax /No. of equity shares
ABC Ltd. = ` 50,00,000/10,00,000 = ` 5
XYZ Ltd. = ` 18,00,000 / 6,00,000 = ` 3
(ii) Number of Shares XYZ limited’s shareholders will get in ABC Ltd. based on market
value per share = ` 28/ 42  6,00,000 = 4,00,000 shares
Total number of equity shares of ABC Ltd. after merger = 10,00,000 + 4,00,000 =
14,00,000 shares
Earnings per share after merger = ` 50,00,000 + 18,00,000/14,00,000 = ` 4.86
(iii) Calculation of exchange ratio to ensure shareholders of XYZ Ltd. to earn the same
as was before merger:
Shares to be exchanged based on EPS = (` 3/` 5)  6,00,000 = 3,60,000 shares
EPS after merger = (` 50,00,000 + 18,00,000)/13,60,000 = ` 5
Total earnings in ABC Ltd. available to shareholders of XYZ Ltd. = 3,60,000  ` 5 =
` 18,00,000.
Thus, to ensure that Earning to members are same as before, the ratio of exchange
should be 0.6 share for 1 share.
5. (i)
Acquirer Company Target Company
Net Profit ` 80 lakhs ` 15.75 lakhs
PE Multiple 10.50 10.00
Market Capitalization ` 840 lakhs ` 157.50 lakhs
Market Price ` 42 ` 105
No. of Shares 20 lakhs 1.50 lakhs
EPS `4 ` 10.50
Maximum Exchange Ratio 4 : 10.50 or 1 : 2.625

Thus, for every one share of Target Company 2.625 shares of Acquirer Company.
(ii) Let x lakhs be the amount paid by Acquirer company to Target Company. Then to
maintain same EPS i.e. ` 4 the number of shares to be issued will be:
(80 lakhs + 15.75 lakhs) - 0.70  15%  x
=4
20 lakhs
95.75 - 0.105 x
=4
20
x = ` 150 lakhs
Thus, ` 150 lakhs shall be offered in cash to Target Company to maintain same
EPS.
6. (i) The number of shares to be issued by A Ltd.:
The Exchange ratio is 0.5
So, new Shares = 1,80,000 x 0.5 = 90,000 shares.
(ii) EPS of A Ltd. After a acquisition:
Total Earnings (` 18,00,000 + ` 3,60,000) ` 21,60,000
No. of Shares (6,00,000 + 90,000) 6,90,000
EPS (` 21,60,000)/6,90,000) ` 3.13
(iii) Equivalent EPS of T Ltd.:
No. of new Shares 0.5
EPS ` 3.13
Equivalent EPS (` 3.13 x 0.5) ` 1.57
(iv) New Market Price of A Ltd. (P/E remaining
unchanged):
Present P/E Ratio of A Ltd. 10 times
Expected EPS after merger ` 3.13
Expected Market Price (`3.13 x 10) ` 31.30
(v) Market Value of merged firm:
Total number of Shares 6,90,000
Expected Market Price ` 31.30
Total value (6,90,000 x 31.30) ` 2,15,97,000
7. Particulars Mark Ltd. Mask Ltd.

EPS ` 2,000 Lakhs/ 200 lakhs ` 400 lakhs / 100 lakhs
= ` 10 `4
Market Price ` 10  10 = ` 100 ` 4  5 = ` 20
(i) The Swap ratio based on current market price is
` 20 / ` 100 = 0.2 or 1 share of Mark Ltd. for 5 shares of Mask Ltd.
No. of shares to be issued = 100 lakh  0.2 = 20 lakhs.
` 2,000 lakhs + ` 400 lakhs

(ii) EPS after merger = = ` 10.91
200 lakhs + 20 lakhs
(iii) Expected market price after merger assuming P/E 10 times.
= ` 10.91  10 = ` 109.10
(iv) Market value of merged firm
= ` 109.10 market price  220 lakhs shares = 240.02 crores
(v) Gain from the merger
Post merger market value of the merged firm ` 240.02 crores
Less: Pre-merger market value
Mark Ltd. 200 Lakhs  ` 100 = 200 crores
Mask Ltd. 100 Lakhs  ` 20 = 20 crores ` 220.00 crores
Gain from merger ` 20.02 crores
Appropriation of gains from the merger among shareholders:
Mark Ltd. Mask Ltd.
Post merger value 218.20 crores 21.82 crores
Less: Pre-merger market value 200.00 crores 20.00 crores
Gain to Shareholders 18.20 crores 1.82 crores
8. Working Notes
(a)
XYZ Ltd. ABC Ltd.
Equity shares outstanding (Nos.) 10,00,000 4,00,000
EPS ` 40 ` 28
Profit ` 400,00,000 ` 112,00,000
PE Ratio 6.25 5.71
(b) EPS after merger

No. of shares to be issued (4,00,000 x 0.70) 2,80,000
Exiting Equity shares outstanding 10,00,000
Equity shares outstanding after merger 12,80,000
Total Profit (` 400,00,000 + ` 112,00,000) ` 512,00,000
EPS ` 40
(i) Impact of merger on EPS of both the companies
XYZ Ltd. ABC Ltd.

EPS after Merger ` 40 ` 28
EPS before Merger ` 40 ` 28*
Nil Nil
* ` 40 x 0.70
(ii) Gain from the Merger if exchange ratio is 1: 1
No. of shares to be issued 4,00,000

Exiting Equity shares outstanding 10,00,000
Equity shares outstanding after merger 14,00,000
Total Profit (` 400,00,000 + ` 112,00,000) ` 512,00,000
EPS ` 36.57
Market Price of Share (` 36.57 x 6.25) ` 228.56
Market Price of Share before Merger ` 160.00
Impact (Increase/ Gain) ` 68.56
(iii) Gain/ loss from the Merger to the shareholders of XYZ Ltd.
Market Price of Share ` 228.56
Market Price of Share before Merger ` 250.00
Loss from the merger (per share) ` 21.44
(iv) Maximum Exchange Ratio acceptable to XYZ Ltd. shareholders
` Lakhs
Market Value of Merged Entity (` 228.57 x 1400000) 3199.98
Less: Value acceptable to shareholders of XYZ Ltd. 2500.00
Value of merged entity available to shareholders of ABC Ltd. 699.98
Market Price Per Share 250
No. of shares to be issued to the shareholders of ABC Ltd. 2.80
(lakhs)
Thus maximum ratio of issue shall be 2.80 : 4.00 or 0.70 share of XYZ Ltd. for
one share of ABC Ltd.
Earning after Merger (40 x 1000000 + 28 x 400000) ` 512 lakhs

PE Ratio of XYZ Ltd. 6.25
Market Value of Firm after Merger (512 x 6.25) ` 3200 lakhs
Existing Value of Shareholders of XYZ Ltd. ` 2500 lakhs
Value of Merged entity available to Shareholders of ABC Ltd. ` 700 lakhs
Market Price per Share ` 250
Total No. of shares to be issued 2.8 lakh
Thus, maximum acceptable ratio shall be 2.80:4.00 i.e. 0.70 share of XYZ Ltd.
for one share of ABC Ltd.
9. (i) Pre-merger EPS and P/E ratios of XYZ Ltd. and ABC Ltd.
Particulars XYZ Ltd. ABC Ltd.
Earnings after taxes 5,00,000 1,25,000
Number of shares outstanding 2,50,000 1,25,000
EPS 2 1
Market Price per share 20 10
(ii) Current Market Price of ABC Ltd. if P/E ratio is 6.4 = ` 1 × 6.4 = ` 6.40
` 20 ` 6.40
Exchange ratio = = 3.125 or = 0.32
` 6.40 ` 20
Post merger EPS of XYZ Ltd.
` 5,00,000 + ` 1,25,000
=
2,50,000 + (1,25,000/ 3.125)
` 6,25,000
= = 2.16
2,90,000
(iii) Desired Exchange Ratio

Total number of shares in post-merged company
Post - merger earnings ` 6,25,000
= = = 3,12,500
Pre - merger EPS of XYZ Ltd 2
Number of shares required to be issued

= 3,12,500 – 2,50,000 = 62,500
Therefore, the exchange ratio is
62,500 : 1,25,000
62,500
= = 0.50
1,25,000
10. (i) SWAP ratio based on current market prices:

EPS before acquisition:
Mani Ltd. : `2,000 lakhs / 200 lakhs: `10
Ratnam Ltd.: `4,000 lakhs / 1,000 lakhs: ` 4
Market price before acquisition:
Mani Ltd.: `10 × 10 `100
Ratnam Ltd.: `4 × 5 ` 20
SWAP ratio: 20/100 or 1/5 i.e. 0.20
(ii) EPS after acquisition:
`(2,000 + 4,000) Lakhs
(200 + 200) Lakhs = `15.00
(iii) Market Price after acquisition:
EPS after acquisition : `15.00
P/E ratio after acquisition 10 × 0.9 9
Market price of share (` 15 X 9) `135.00
(iv) Market value of the merged Co.:
`135 × 400 lakhs shares ` 540.00 Crores
or ` 54,000 Lakhs
(v) Gain/loss per share:
` Crore
Mani Ltd. Ratnam Ltd.
Total value before Acquisition 200 200
Value after acquisition 270 270
Gain (Total) 70 70
No. of shares (pre-merger) (lakhs) 200 1,000
Gain per share (`) 35 7
11.
(i) Exchange Ratio 1:1
New Shares to be issued 2,00,000
Total shares of Rama Ltd. (4,00,000+2,00,000) 6,00,000
Total earnings (` 10,00,000 + ` 7,00,000) ` 17,00,000
New EPS (` 17,00,000/6,00,000) ` 2.83
(ii) Existing EPS of Rama Ltd. ` 2.50
Increase in EPS of Rama Ltd (` 2.83 – ` 2.50) ` 0.33
Existing EPS of Krishna Ltd. ` 3.50
Decrease in EPS of Krishna Ltd. (` 3.50 – ` 2.83) ` 0.67
(iii) P/E ratio of new firm (expected to remain same) 14 times
New market price (14 × ` 2.83) ` 39.62
Total No. of Shares 6,00,000
Total market Capitalization (6,00,000 × ` 39.62) ` 2,37,72,000
Existing market capitalization (` 70,00,000 + ` 1,40,00,000) ` 2,10,00,000
Total gain ` 27,72,000
(iv)
Rama Ltd. Krishna Ltd Total
No. of shares after merger 4,00,000 2,00,000 6,00,000
Market price ` 39.62 ` 39.62 ` 39.62
Total Mkt. Values ` 1,58,48,000 ` 79,24,000 ` 2,37,72,000
Existing Mkt. values ` 1,40,00,000 ` 70,00,000 ` 2,10,00,000
Gain to share holders ` 18,48,000 ` 9,24,000 ` 27,72,000
or ` 27,72,000  3 = ` 9,24,000 to Krishna Ltd. and ` 18,48,000 to Rama Ltd. (in

2: 1 ratio)
12. (i) Calculation of new EPS of M Co. Ltd.
No. of equity shares to be issued by M Co. Ltd. to N Co. Ltd.
= 4,00,000 shares × ` 160/` 200 = 3,20,000 shares
Total no. of shares in M Co. Ltd. after acquisition of N Co. Ltd.
= 16,00,000 + 3,20,000 = 19,20,000
Total earnings after tax [after acquisition]
= 80,00,000 + 24,00,000 = 1,04,00,000

` 1,04,00,000
EPS = = ` 5.42
19,20,000 equity shares
(ii) Calculation of exchange ratio which would not diminish the EPS of N Co. Ltd. after
its merger with M Co. Ltd.
Current EPS:
` 80,00,000
M Co. Ltd. = =`5
` 24,00,000
N Co. Ltd. = =`6
Exchange ratio = 6/5 = 1.20

No. of new shares to be issued by M Co. Ltd. to N Co. Ltd.
= 4,00,000 × 1.20 = 4,80,000 shares
Total number of shares of M Co. Ltd. after acquisition
= 16,00,000 + 4,80,000 = 20,80,000 shares
` 1,04,00,000
EPS [after merger] = =`5
20,80,000 shares
Total earnings in M Co. Ltd. available to new shareholders of N Co. Ltd.

= 4,80,000 × ` 5 = ` 24,00,000
Recommendation: The exchange ratio (6 for 5) based on market shares is
beneficial to shareholders of 'N' Co. Ltd.
13. (i) Pre Merger Market Value of Per Share
P/E Ratio X EPS
Longitude Ltd. ` 8 X 15 = ` 120.00
Latitude Ltd. ` 5 X 10 = ` 50.00
(ii) (1) Maximum exchange ratio without dilution of EPS
Pre Merger PAT of Longitude Ltd. ` 120 Lakhs
Pre Merger PAT of Latitude Ltd. ` 80 Lakhs
Combined PAT ` 200 Lakhs
Longitude Ltd. ’s EPS `8
Maximum number of shares of Longitude after merger 25 Lakhs

(` 200 lakhs/` 8)
Existing number of shares 15 Lakhs
Maximum number of shares to be exchanged 10 Lakhs
Maximum share exchange ratio 10:16 or 5:8
(2) Maximum exchange ratio without dilution of Market Price Per Share
Pre Merger Market Capitalization of Longitude Ltd. ` 1800 Lakhs
(` 120 × 15 Lakhs)
Pre Merger Market Capitalization of Latitude Ltd. ` 800 Lakhs
(` 50 × 16 Lakhs)
Combined Market Capitalization ` 2600 Lakhs
Current Market Price of share of Longitude Ltd. ` 120
Maximum number of shares to be exchanged of Longitude 21.67 Lakhs
(surviving company) (` 2600 Lakhs/` 120)
Current Number of Shares of Longitude Ltd. 15.00 Lakhs
Maximum number of shares to be exchanged (Lakhs) 6.67 Lakhs
Maximum share exchange ratio 6.67:16 or 0.4169:1
14.
P Ltd. R Ltd.
Profit before Tax (` in crore) 15 13.50
Tax 30% (` in crore) 4.50 4.05
Profit after Tax (` in crore) 10.50 9.45
Earning per Share (` ) 10.50 9.45
= ` 0.42 = ` 0.63
25 15
Price of Share before Merger ` 0.42 x 12 = ` 5.04 `0.63 x 9 = ` 5.67
(EPS x P/E Ratio)
(i) Market Value of company
P Ltd. = ` 5.04 x 25 Crore = ` 126 crore
R Ltd. = ` 5.67 x 15 Crore = ` 85.05 crore
Combined = ` 126 + ` 85.05 = ` 211.05 Crores
After Merger
P Ltd. R Ltd.
No. of Shares 25 crores 4
15x = 12 crores
5
Combined 37 crores
% of Combined Equity Owned 25 12
x100 = 67.57% x100 = 32.43%
37 37
(ii)  Value of Original Shareholders
P Ltd. R Ltd.
` 211.05 crore x 67.57% ` 211.05 crore x 32.43%
= ` 142.61 = ` 68.44
Combined Value of Entity 211.05 crore
No. of shares after Merger 37 crore
Value of Per Share ` 5.70405
Value of P Ltd. Shareholders (25 crores x ` 5.70405) ` 142.60 crore
Value of R Ltd. Shareholders (12 crores x ` 5.70405) ` 68.45 crore
(iii)  Price per Share after Merger
`19.95crore
EPS = = ` 0.539 per share
37crore
P/E Ratio = 12
Market Value Per Share = ` 0.539 X 12 = ` 6.47
Total Market Value = ` 6.47 x 37 crore = ` 239.39 crore
MarketValue 239.39 crore
Price of Share = = = ` 6.47
Number of Shares 37 crore
(iv) Effect on Share Price

P Ltd.
Gain/loss (-) per share = ` 6.47 – ` 5.04 = ` 1.43
6.47 − 5.04
i.e.  100 = 0.284 or 28.4%
5.04
 Share price would rise by 28.4%
R Ltd.
4
6.47 x = ` 5.18
5
Gain/loss (-) per share = ` 5.18 – ` 5.67 = (-` 0.49)
5.18 − 5.67
i.e.  100 (-) 0.0864 or (-) 8.64%
5.67
 Share Price would decrease by 8.64%.
15. Compute Value of Equity
Simple Ltd.
` in Lacs
High Growth Medium Growth Slow Growth
Debit + Equity 820 550 410
Less: Debt 460 460 460
Equity 360 90 -50
Since the Company has limited liability the value of equity cannot be negative therefore the
value of equity under slow growth will be taken as zero because of insolvency risk and the
value of debt is taken at 410 lacs. The expected value of debt and equity can then be
calculated as:
Simple Ltd.
` in Lacs
High Growth Medium Growth Slow Growth Expected Value
Prob. Value Prob. Value Prob. Value
Debt 0.20 460 0.60 460 0.20 410 450
Equity 0.20 360 0.60 90 0.20 0 126
820 550 410 576
Dimple Ltd.
` in Lacs
High Growth Medium Growth Slow Growth Expected
Value
Prob. Value Prob. Value Prob. Value
Equity 0.20 985 0.60 760 0.20 525 758
Debt 0.20 65 0.60 65 0.20 65 65
1050 825 590 823
Expected Values
` in Lacs
Equity Debt
Simple Ltd. 126 Simple Ltd. 450
Dimple Ltd. 758 Dimple Ltd. 65
884 515
16. (i) Working Notes:

Present Value of Cash Flows (CF) upto 5 years
Year CF of Yes PVF PV of CF CF of PV of CF of
End Ltd. @15% (` lakhs) Merged Merged
(` lakhs) Entity Entity
(` lakhs) (` lakhs)
1 175 0.870 152.25 400 348.00
2 200 0.756 151.20 450 340.20
3 320 0.658 210.56 525 345.45
4 340 0.572 194.48 590 337.48
5 350 0.497 173.95 620 308.14
882.44 1679.27
PV of Cash Flows of Yes Ltd. after the forecast period

CF5 (1 + g) 350(1 + 0.05) 367.50
TV5 = = = = `3675 lakhs
Ke − g 0.15 − 0.05 0.10
PV of TV5 = `3675 lakhs x 0.497 = `1826.475 lakhs

PV of Cash Flows of Merged Entity after the forecast period
CF5 (1 + g) 620(1 + 0.06) 657.20
TV5 = = = = `7302.22 lakhs
Ke − g 0.15 − 0.06 0.09
PV of TV5 = `7302.22 lakhs x 0.497 = `3629.20 lakhs

Value of Yes Ltd.
Before merger (`lakhs) After merger (`lakhs)
PV of CF (1-5 years) 882.440 1679.27
Add: PV of TV5 1826.475 3629.20
2708.915 5308.47
(ii) Value of Acquisition

= Value of Merged Entity – Value of Yes Ltd.
= `5308.47 lakhs – `2708.915 lakhs = `2599.555 lakhs
(iii) Gain to Shareholders of Yes Ltd.
1
Share of Yes Ltd. in merged entity = `5308.47 lakhs x = `3538.98 lakhs
1.5
Gain to shareholder = Share of Yes Ltd. in merged entity – Value of Yes Ltd. before
merger
= `3538.98 lakhs - `2708.915 = `830.065 lakhs
17. Swap Ratio
Efficient Ltd. Healthy Ltd.
Market capitalization 500 lakhs 750 lakhs
No. of shares 10 lakhs 7.5 lakhs
Market Price per share ` 50 ` 100
P/E ratio 10 5
EPS `5 ` 20
Profit ` 50 lakh ` 150 lakh
Share capital ` 100 lakh ` 75 lakh
Reserves and surplus ` 300 lakh ` 165 lakh
Total ` 400 lakh ` 240 lakh
Book Value per share ` 40 ` 32
(i) Calculation of Swap Ratio
EPS 1 : 4 i.e. 4.0  40% 1.6

Book value 1 : 0.8 i.e. 0.8  25% 0.2
Market price 1 : 2 i.e. 2.0  35% 0.7
Total 2.5
Swap ratio is for every one share of Healthy Ltd., to issue 2.5 shares of Efficient Ltd.
Hence, total no. of shares to be issued 7.5 lakh  2.5 = 18.75 lakh shares.
Promoter’s holding = 4.75 lakh shares + (5  2.5 = 12.5 lakh shares) = 17.25 lakh
i.e. Promoter’s holding % is (17.25 lakh/28.75 lakh)  100 = 60%.
Calculation of EPS, Market price, Market capitalization and free float market
capitalization.
(ii) Total No. of shares 10 lakh + 18.75 lakh = 28.75 lakh

Total capital 100 lakh + 187.5 lakh = ` 287.5 lakh
Total profit 50 lakh + 150 lakh 200
EPS = = = ` 6.956
No. of shares 28.75 lakh 28.75
(iii) Expected market price EPS 6.956  P/E 10 = ` 69.56
Market capitalization = ` 69.56 per share  28.75 lakh shares
= ` 1,999.85 lakh
(iv) Free float of market capitalization = ` 69.56 per share  (28.75 lakh  40%)
= ` 799.94 lakh
18. SWAP RATIO
Abhiman Ltd. Swabhiman Ltd.
(`) (`)
Share capital 200 lacs 100 lacs
Free reserves & surplus 900 lacs 600 lacs
Total 1100 lacs 700 lacs
No. of shares 2 lacs 10 lacs
Book value for share ` 550 ` 70
Promoters Holding 50% 60%
Non promoters holding 50% 40%
Free float market capitalization (Public) 500 lacs ` 156 lacs
Total Market Cap 1000 lacs 390 lacs
No. of shares 2 lacs 10 lacs
P/E ratio 10 4
EPS ` 50.00 ` 9.75
Calculation of SWAP Ratio

Book Value 1:0.1273 0.1273  25% 0.031825
EPS 1:0.195 0.195  50% 0.097500
Market Price 1:0.078 0.078  25% 0.019500
Total 0.148825
(i) SWAP Ratio is 0.148825 shares of Abhiman Ltd. for every share of Swabhiman Ltd.
Total No. of shares to be issued = 10 lakh  0.148825 = 148825 shares
(ii) Book value, EPS & Market Price.
Total No. shares = 200000 +148825=348825
Total capital = `200 lakh + `148.825 lac = ` 348.825 lac
Reserves = ` 900 lac + ` 551.175 lac = ` 1451.175 lac
` 348.825 lac + ` 1451.175 lac
Book value Per Share = = ` 516.02
3.48825 lac
or ` 516.02 x 0.148825 = ` 76.80
Total Capital 1100lac + 700 lac
or = = = ` 516.02
No. of Shares 348825
Total Pr ofit ` 100 lac + ` 97.50 lac
EPS = = = ` 56.62
No. of shares 3.48825 lac
or ` 56.62 x 0.148825 = ` 8.43
Expected market price = ` 56.62  PE Ratio= ` 56.62  10 = ` 566.20
or ` 566.20 x 0.148825 = ` 84.26
19.
(i) E Ltd. H Ltd.
Market capitalisation 1000 lakhs 1500 lakhs
No. of shares 20 lakhs 15 lakhs
Market Price per share ` 50 ` 100
P/E ratio 10 5
EPS `5 ` 20
Profit ` 100 lakh ` 300 lakh
Share capital ` 200 lakh ` 150 lakh
Reserves and surplus ` 600 lakh ` 330 lakh
Total ` 800 lakh ` 480 lakh
(ii) Calculation of Swap Ratio

EPS 1 : 4 i.e. 4.0  40% 1.6
Book value 1 : 0.8 i.e. 0.8  25% 0.2
Market price 1 : 2 i.e. 2.0  35% 0.7

Total 2.5
Swap ratio is for every one share of H Ltd., to issue 2.5 shares of E Ltd. Hence, total
no. of shares to be issued 15 lakh  2.5 = 37.50 lakh shares
(iii) Promoter’s holding = 9.50 lakh shares + (10 2.5 = 25 lakh shares) = 34.50 lakh i.e.
Promoter’s holding % is (34.50 lakh/57.50 lakh)  100 = 60%.
(iv) Calculation of EPS after merger
Total No. of shares 20 lakh + 37.50 lakh = 57.50 lakh
Total profit 100 lakh + 300 lakh 400
EPS = = = ` 6.956
No. of shares 57.50 lakh 57.50
(v) Calculation of Market price and Market capitalization after merger
Expected market price EPS 6.956  P/E 10 = ` 69.56
Market capitalization = ` 69.56 per share 57.50 lakh shares
= ` 3,999.70 lakh or ` 4,000 lakh
(vi) Free float of market capitalization = ` 69.56 per share  (57.50 lakh  40%) = `
1599.88 lakh
20. (a) Swap Ratio
Abhiman Ltd. Abhishek Ltd.

Share Capital 200 Lakh 100 Lakh
Free Reserves 800 Lakh 500 Lakh
Total 1000 Lakh 600 Lakh
No. of Shares 2 Lakh 10 Lakh
Promoter’s holding 50% 60%
Non promoter’s holding 50% 40%
Free Float Market Cap. i.e. 400 Lakh 128 Lakh
relating to Public’s holding
Hence Total market Cap. 800 Lakh 320 Lakh
No. of Shares 2 Lakh 10 Lakh
P/E Ratio 10 4
EPS 40 8
Profits (` 2 X 40 lakh) ` 80 lakh -
(` 8 X 10 lakh) - ` 80 lakh
Calculation of Swap Ratio
Book Value 1 : 0.12 i.e. 0.12 x 25% 0.03
EPS 1 : 0.2 0.20 x 50% 0.10
Market Price 1 : 0.08 0.08 x 25% 0.02
Total 0.15
Swap ratio is for every one share of Abhishek Ltd., to issue 0.15 shares of Abhiman
Ltd. Hence total no. of shares to be issued.
10 Lakh x 0.15 = 1.50 lakh shares
(b) Book Value, EPS & Market Price
Total No of Shares 2 Lakh + 1.5 Lakh = 3.5 Lakh
Total Capital ` 200 Lakh + ` 150 Lakh = ` 350 Lakh
Reserves ` 800 Lakh + ` 450 Lakh = ` 1,250 Lakh
Book Value ` 350 Lakh + ` 1,250 Lakh = ` 457.14 per share
3.5 Lakh
Total Profit ` 80 Lakh +` 80 Lakh ` 160 Lakh
EPS = = = ` 45.71
No. of Share 3.5 Lakh 3.5
Expected Market Price EPS (` 45.71) x P/E Ratio (10) = ` 457.10
(c) (i) Promoter’s holding
Promoter’s Revised Abhiman 50% i.e. 1.00 Lakh shares
Holding Abhishek 60% i.e. 0.90 Lakh shares
Total 1.90 Lakh shares
Promoter’s % = 1.90/3.50 x 100 = 54.29%
(ii) Free Float Market Capitalisation
Free Float Market = (3.5 Lakh – 1.9 Lakh) x ` 457.10
Capitalisation = ` 731.36 Lakh
(iii) (a) & (b)

Revised Capital ` 350 Lakh + ` 175 Lakh = ` 525 Lakh
No. of shares before Split (F.V ` 100) 5.25 Lakh
No. of Shares after Split (F.V. ` 5 ) 5.25 x 20 = 105 Lakh
EPS 160 Lakh / 105 Lakh = 1.523
Book Value Cap. ` 525 Lakh + ` 1075 Lakh
No. of Shares =105 Lakh
= ` 15.238 per share
21. As per T Ltd.’s Offer
` in lakhs
(i) Net Consideration Payable
7 times EBIDAT, i.e. 7 x ` 115.71 lakh 809.97
Less: Debt 240.00
569.97
(ii) No. of shares to be issued by T Ltd
` 569.97 lakh/` 220 (rounded off) (Nos.) 2,59,000
(iii) EPS of T Ltd after acquisition
Total EBIDT (` 400.86 lakh + ` 115.71 lakh) 516.57
Less: Interest (` 58 lakh + ` 30 lakh) 88.00
428.57
Less: 30% Tax 128.57
Total earnings (NPAT) 300.00
Total no. of shares outstanding 14.59 lakh

(12 lakh + 2.59 lakh)
EPS (` 300 lakh/ 14.59 lakh) ` 20.56
(iv) Expected Market Price:
Pre-acquisition P/E multiple:
EBIDAT (` in lakhs) 400.86
10
Less: Interest ( 580 X )(` in lakhs) 58.00
100
342.86
Less: 30% Tax (` in lakhs) 102.86
EAT (` in lakhs) 240.00

No. of shares (lakhs) 12.00
EPS ` 20.00
220
Hence, PE multiple 11
20
Expected market price after acquisition (` 20.56 x 11) ` 226.16
As per E Ltd’s Plan
` in lakhs
(i) Net consideration payable
6 lakhs shares x ` 110 660
(ii) No. of shares to be issued by T Ltd
` 660 lakhs ÷ ` 220 3 lakh
(iii) EPS of T Ltd after Acquisition
NPAT (as per earlier calculations) 300.00
Total no. of shares outstanding (12 lakhs + 3 lakhs) 15 lakh
Earning Per Share (EPS) ` 300 lakh/15 lakh ` 20.00
(iv) Expected Market Price (` 20 x 11) 220.00
(v) Advantages of Acquisition to T Ltd

Since the two companies are in the same industry, the following advantages could
accrue:
— Synergy, cost reduction and operating efficiency.
— Better market share.
— Avoidance of competition
22. Share holders’ funds (` Lakhs)
Particulars Fortune India Ltd. Fortune Pharma Ltd. Fortune India (FMCG)
Ltd.
Assets 70,000 25,100 44,900
Outside liabilities 25,000 4,100 20,900
Net worth 45,000 21,000 24,000
1. Calculation of Shares of Fortune Pharma Ltd. to be issued to shareholders of

Fortune India Ltd.
Fortune Pharma Ltd.

Estimated Profit (` in lakhs) 1,470
Estimated market price (`) 24.5
Estimated P/E 25
Estimated EPS (`) 0.98
No. of shares lakhs 1,500
Hence, Ratio is 1 share of Fortune Pharma Ltd. for 2 shares of Fortune India Ltd.
OR for 0.50 share of Fortune Pharma Ltd. for 1 share of Fortune India Ltd.
2. Expected market price of Fortune India (FMCG) Ltd.
Fortune India (FMCG) Ltd.

Estimated Profit (` in lakhs) 11,400
No. of equity shares (` in lakhs) 3,000
Estimated EPS (`) 3.8
Estimated P/E 42
Estimated market price (`) 159.60
3. Book value per share

Fortune Pharma Ltd. Fortune India (FMCG) Ltd.
Net worth (`in lakhs) 21,000 24,000
No. of shares (` in lakhs) 1,500 3,000
Book value of shares ` 14 `8
23. (i) Net asset value
H Ltd. ` 1300 Crores − ` 300 Crores

= ` 285.71
3.50 Crores
B Ltd. ` 31.50 Crores
= ` 48.46
0.65 Crores
(ii) Earning capitalization value

H Ltd. ` 300 Crores / 0.08
= ` 1071.43*
3.50 Crores
B Ltd. ` 10 Crores / 0.08
= ` 192.31
0.65 Crores
* Alternatively, Contingent Liability can also be deducted from this Valuation.
(iii) Fair value
H Ltd. ` 285.71 1 + ` 1071.43  3
= ` 875
4
B Ltd. ` 48.46  1 + ` 192.31 3
= ` 156.3475
4
Exchange ratio `156.3475/ `875 = 0.1787
H Ltd should issue its 0.1787 share for each share of B Ltd.
Note: In above solution it has been assumed that the contingent liability will
materialize at its full amount.
24. (i) Market value of Companies before Merger
Particulars RIL SIL
EPS `2 Re.1
P/E Ratio 10 5
Market Price Per Share ` 20 `5
Equity Shares 10,00,000 10,00,000
Total Market Value 2,00,00,000 50,00,000
(ii) Post Merger Effects on RIL
`
Post-merger earnings 30,00,000
Exchange Ratio (1:4)
No. of equity shares o/s (10,00,000 + 2,50,000) 12,50,000
EPS: 30,00,000/12,50,000 2.4
PE Ratio 10
Market Value 10 x 2.4 24
Total Value (12,50,000 x 24) 3,00,00,000
Gains From Merger: `

Post-Merger Market Value of the Firm 3,00,00,000
Less: Pre-Merger Market Value
RIL 2,00,00,000
SIL 50,00,000 2,50,00,000
Total gains from Merger 50,00,000
Apportionment of Gains between the Shareholders:

Particulars RIL (`) SIL (`)
Post-Merger Market Value:
10,00,000 x 24 2,40,00,000 --
2,50,000 x 24 - 60,00,000
Less: Pre-Merger Market Value 2,00,00,000 50,00,000
Gains from Merger: 40,00,000 10,00,000
Thus, the shareholders of both the companies (RIL + SIL) are better off than before
(iii) Post-Merger Earnings:
Increase in Earnings by 20%
New Earnings: ` 30,00,000 x (1+0.20) ` 36,00,000
No. of equity shares outstanding: 12,50,000
EPS (` 36,00,000/12,50,000) ` 2.88
PE Ratio 10
Market Price Per Share: = `2.88 x 10 ` 28.80
Shareholders will be better-off than before the merger situation.
25. (i) For BCD Ltd., before acquisition
The cost of capital of BCD Ltd. may be calculated by using the following formula:
Dividend
+ Growth %
Pr ice
Cost of Capital i.e., Ke = (0.60/20) + 0.07 = 0.10
After acquisition g (i.e. growth) becomes 0.08
Therefore, price per share after acquisition = 0.60/(0.10-0.08) = `30
The increase in value therefore is = `(30-20) x 5,00,000 = `50,00,000/-
(ii) To share holders of BCD Ltd. the immediate gain is `100 – `20x4 = `20 per share
The gain can be higher if price of shares of AFC Ltd. rise following merger which
they should undertake.
To AFC Ltd. shareholders (` (In lakhs)
Value of Company now 1,000
Value of BCD Ltd. 150
1,150
No. of shares 11.25
 Value per share 1150/11.25 = `102.22
Gain to shareholders of BCD Ltd. = `102.22 – `(4 x 20) = `22.22

Gain to shareholders of AFC Ltd. = `102.22 – `100.00 = `2.22
(iii) Gain to shareholders of AFC Ltd:-
Earnings of BCD Ltd. (5,00,000 x 2.50) `12,50,000/-
Less: Loss of earning in cash (5,00,000 x ` 22 x 0.10) `11,00,000/-
Net Earning ` 1,50,000/-
Number of shares 10,00,000
Net increase in earning per share 0.15
P/E ratio of AFC Ltd. = 100/8 = 12.50
Therefore, Gain per share of shareholders of AFC Ltd. = 0.15x12.50 = `1.88
Gain to the shareholders of BCD Ltd. ` (22-20) = `2/- per share
Post-Merger Earnings ` 81,50,000
(10,00,000 x ` 8 + 5,00,000 x ` 2.5 – 11,00,000)
 81, 50, 000  ` 8.15
EPS after Merger  
 10, 00, 000 
PE Ratio 12.50
Post Merger Price of Share (` 8.15 x 12.50) ` 101.875
Less: Price before merger ` 100.00
` 1.875
Say ` 1.88
26. Price/share of AB Ltd. for determination of number of shares to be issued

= (` 570 + ` 430)/2 = ` 500
Value of XY Ltd based on future cash flow capitalization

(105x0.93)+(120x0.86)+(125x0.79)+(120x0.74)x(300x0.68) ` lakhs 592.40
Value of XY Ltd based on net assets ` lakhs 250.00
Average value (592.40+250)/2 421.20
No. of shares in AB Ltd to be issued ` 4,21,20,000/500 Nos. 84240
Basis of allocation of shares
Fully paid equivalent shares in XY Ltd. (20+5) lakhs 2500000
Distribution to fully paid shareholders 84240x20/25 67392
Distribution to partly paid shareholders 84240-67392 16848
27. (i) Determination of EPS, P/E Ratio, ROE and BVPS of R Ltd. & S Ltd.
R Ltd. S Ltd.
EAT (`) 5,33,000 2,49,600
N 200000 160000
EPS (EAT÷N) 2.665 1.56
Market Price Per Share 50 20
PE Ratio (MPS/EPS) 18.76 12.82
Equity Fund (Equity Value) 2400000 1600000
BVPS (Equity Value ÷ N) 12 10
ROE (EAT÷ EF) or 0.2221 0.156
ROE (EAT ÷ EF) x 100 22.21% 15.60%
(ii) Determination of Growth Rate of EPS of R Ltd.& S Ltd.
R Ltd. S Ltd.
Retention Ratio (1-D/P Ratio) 0.80 0.70
Growth Rate (ROE x Retention Ratio) or 0.1777 0.1092
Growth Rate (ROE x Retention Ratio) x 100 17.77% 10.92%
(iii) Justifiable equity share exchange ratio
(a) Market Price Based = MPS S/MPSR = ` 20/ ` 50 = 0.40:1 (lower limit)
(b) Intrinsic Value Based = ` 25/ ` 50 = 0.50:1 (max. limit)
Since R Ltd. has higher EPS, PE, ROE and higher growth expectations the
negotiated term would be expected to be closer to the lower limit, based on existing
share price.
28. Market price per share (MPS) = EPS X P/E ratio or P/E ratio = MPS/EPS
(i) Determination of EPS, P/E ratio, ROE and BVPS of BA Ltd. and DA Ltd.
BA Ltd. DA Ltd.
Earnings After Tax (EAT) ` 2,10,000 ` 99,000
No. of Shares (N) 100000 80000
EPS (EAT/N) ` 2.10 ` 1.2375
Market price per share (MPS) 40 15
P/E Ratio (MPS/EPS) 19.05 12.12
Equity Funds (EF) ` 12,00,000 ` 8,00,000
BVPS (EF/N) 12 10
ROE (EAT/EF) × 100 17.50% 12.37%
(ii) Estimation of growth rates in EPS for BA Ltd. and DA Ltd.
Retention Ratio (1-D/P ratio) 0.6 0.4

Growth Rate (ROE × Retention Ratio) 10.50% 4.95%
(iii) Justifiable equity shares exchange ratio
(a) Intrinsic value based = `20 / `40 = 0.5:1 (upper limit)

(b) Market price based = MPSDA/MPSBA = `15 / `40 =0.375:1(lower limit)
Since, BA Ltd. has a higher EPS, ROE, P/E ratio and even higher EPS growth
expectations, the negotiable terms would be expected to be closer to the lower limit,
based on the existing share prices.
(iv) Calculation of Post merger EPS and its effects
Particulars BA Ltd. DA Ltd. Combined

EAT (`) (i) 2,10,000 99,000 3,09,000
Share outstanding (ii) 100000 80000 132000*
EPS (`) (i) / (ii) 2.1 1.2375 2.341
EPS Accretion (Dilution) (Re.) 0.241 (0.301***)
(v) Estimation of Post merger Market price and other effects

Particulars BA Ltd. DA Ltd. Combined
EPS (`) (i) 2.1 1.2375 2.341
P/E Ratio (ii) 19.05 12.12 19.05
MPS (`) (i) / (ii) 40 15 44.6
MPS Accretion (`) 4.6 2.84***
* Shares outstanding (combined) = 100000 shares + (.40 × 80000)= 132000 shares

** EPS claim per old share = `2.34 × 0.4 ` 0.936
EPS dilution = `1.2375 – ` 0.936 ` 0.3015
***S claim per old share (` 44.60 × 0.4) ` 17.84
Less: MPS per old share ` 15.00
` 2.84
29. (a) Swap Ratio
Gross NPA 5:40 5/40 x 30% 0.0375
CAR 5:16 5/16 x 28% 0.0875
Market Price 12:96 12/96 x 32% 0.0400
Book Value Per Share 12:120 12/120x 10% 0.0100
0.1750
Thus, for every share of Weak Bank, 0.1750 share of Strong Bank shall be issued.
Calculation of Book Value Per Share
Particulars Weak Bank Strong Bank

(W) (S)
Share Capital (` Lakhs) 150 500
Reserves & Surplus (` Lakhs) 80 5,500
230 6,000
Less: Preliminary Expenses (` Lakhs) 50 --
Net Worth or Book Value (` Lakhs) 180 6,000
No. of Outstanding Shares (Lakhs) 15 50
Book Value Per Share (`) 12 120
(b) No. of equity shares to be issued:

150
× 0.1750 = 2.625 lakh shares
10
(c) Balance Sheet after Merger
Calculation of Capital Reserve
Book Value of Shares ` 180.00 lac
Less: Value of Shares issued ` 26.25 lac
Capital Reserve ` 153.75 lac
Balance Sheet
` lac ` lac
Paid up Share Capital 526.25 Cash in Hand & RBI 2900.00
Reserves & Surplus 5500.00 Balance with other banks 2000.00
Capital Reserve 153.75 Investment 20100.00
Deposits 48000.00 Advances 30500.00
Other Liabilities 3390.00 Other Assets 2070.00
57570.00 57570.00
(d) Calculation CAR & Gross NPA % of Bank ‘S’ after merger
Total Capital
CAR / CRWAR =
Risky Weighted Assets
Weak Bank Strong Bank Merged
5% 16%
Total Capital ` 180 lac ` 6000 lac ` 6180 lac
Risky Weighted Assets ` 3600 lac ` 37500 lac ` 41100 lac
6180
CAR = × 100 = 15.04%
41100
Gross NPA
GNPA Ratio =  100
Gross Advances
Weak Bank Strong Bank Merged

GNPA (Given) 0.40 0.05
GNPA R GNPA S
0.40 = 0.05 =
` 3500 lac ` 27000 lac
Gross NPA ` 1400 lac ` 1350 lac ` 2750 lac
30. Calculation of Purchase Consideration

`
Issue of Share 35000 x `15 5,25,000
External Liabilities settled 5,00,000
13% Debentures 3,00,000
13,25,000
Less: Realization of Debtors and Inventories 2,00,000
Cash 50,000
10,75,000
Net Present Value = PV of Cash Inflow + PV of Demerger of Leopard Ltd. – Cash Outflow
= ` 5,00,000 PVAF(16%,6) + ` 2,00,000 PVF(16%, 6) – ` 10,75,000
= ` 5,00,000 x 3.684 + ` 2,00,000 x 0.410 – ` 10,75,000
= ` 18,42,000 + ` 82,000 – ` 10,75,000
= ` 8,49,000
Since NPV of the decision is positive it is advantageous to acquire Leopard Ltd.
31. (i) Calculation of maximum price per share at which PQR Ltd. can offer to pay for XYZ
Ltd.’s share
Market Value (10,00,000 x ` 24) ` 2,40,00,000
Synergy Gain ` 80,00,000
Saving of Overpayment ` 30,00,000
` 3,50,00,000
Maximum Price (` 3,50,00,000/10,00,000) ` 35

Let ER be the swap ratio then,
24×10,00,000+40×15,00,000+ 80,00,000+30,00,000
40=
15,00,000+10,00,000×ER
ER = 0.875
40
MP = PE x EPS x ER = x ` 4 x 0.875 = ` 35
4
(ii) Calculation of minimum price per share at which the management of XYZ Ltd.’s will
be willing to offer their controlling interest
Value of XYZ Ltd.’s Management Holding (40% of 10,00,000 x ` 24) ` 96,00,000
Add: PV of loss of remuneration to top management ` 30,00,000
` 1,26,00,000
No. of Shares 4,00,000
Minimum Price (` 1,26,00,000/4,00,000) ` 31.50
14
STARTUP FINANCE
LEARNING OUTCOMES
❑ Introduction of Startup finance
❑ Pitch Presentation
❑ Sources of Funding
❑ Startup financing through Venture Capital Financing
1. THE BASICS OF STARTUP FINANCING

Startup financing means some initial infusion of money needed to turn an idea (by starting a
business) into reality. While starting out, big lenders like banks etc. are not interested in a startup
business. The reason is that when you are just starting out, you're not at the point yet where a
traditional lender or investor would be interested in you. So that leaves one with the option of
selling some assets, borrowing against one’s home, asking loved ones i.e. family and friends for
loans etc. But that involves a lot of risk, including the risk of bankruptcy and strained relationships
with friends and family.
So, the pertinent question is how to keep loans from family and friends strictly business like. This
is the hard part behind starting a business -- putting so much at risk but doing so is essential. It's
what sets entrepreneurs apart from people who collect regular salaries as employees.
A good way to get success in the field of entrepreneurship is to speed up initial operations as
quickly as possible to get to the point where outside investors can see and feel the business
venture, as well as understand that a person has taken some risk reaching it to that level.
Some businesses can also be bootstrapped (attempting to found and build a company
from personal finances or from the operating revenues of the new company).They can be built up
quickly enough to make money without any help from investors who might otherwise come in and
start dictating the terms.
In order to successfully launch a business and get it to a level where large investors are interested
in putting their money, requires a strong business plan. It also requires seeking advice from
experienced entrepreneurs and experts -- people who might invest in the business sometime in the
future.
2. SOME OF THE INNOVATIVE WAYS TO FINANCE A

STARTUP
Every startup needs access to capital, whether for funding product development, acquiring
machinery and inventory or paying salaries to its employee. Most entrepreneurs think first of bank
loans as the primary source of money, only to find out that banks are really the least likely
benefactors for startups. So, innovative measures include maximizing non-bank financing.
Here are some of the sources for funding a startup:
(i) Personal financing: It may not seem to be innovative but you may be surprised to note
that most budding entrepreneurs never thought of saving any money to start a business. This is
important because most of the investors will not put money into a deal if they see that you have
not contributed any money from your personal sources.
(ii) Personal credit lines: One qualifies for personal credit line based on one’s personal credit
efforts. Credit cards are a good example of this. However, banks are very cautious while granting
personal credit lines. They provide this facility only when the business has enough cash flow to
repay the line of credit.
(iii) Family and friends: These are the people who generally believe in you, without even
thinking that your idea works or not. However, the loan obligations to friends and relatives should
always be in writing as a promissory note or otherwise.
(iv) Peer-to-peer lending: In this process group of people come together and lend money to
each other. Peer to peer lending has been there for many years. Many small and ethnic business
groups having similar faith or interest generally support each other in their start up endeavors.
(v) Crowdfunding: Crowdfunding is the use of small amounts of capital from a large number of
individuals to finance a new business initiative. Crowdfunding makes use of the easy accessibility
STARTUP FINANCE 714.3
of vast networks of people through social media and crowdfunding websites to bring investors and
entrepreneurs together.
(vi) Microloans: Microloans are small loans that are given by individuals at a lower interest to a
new business ventures. These loans can be issued by a single individual or aggregated across a
number of individuals who each contribute a portion of the total amount.
(vii) Vendor financing: Vendor financing is the form of financing in which a company lends
money to one of its customers so that he can buy products from the company itself. Vendor
financing also takes place when many manufacturers and distributors are convinced to defer
payment until the goods are sold. This means extending the payment terms to a longer period for
e.g. 30 days payment period can be extended to 45 days or 60 days. However, this depends on
one’s credit worthiness and payment of more money.
(viii) Purchase order financing: The most common scaling problem faced by startups is the
inability to find a large new order. The reason is that they don’t have the necessary cash to
produce and deliver the product. Purchase order financing companies often advance the required
funds directly to the supplier. This allows the completion of transaction and profit flows up to the
new business.
(ix) Factoring accounts receivables: In this method, a facility is given to the seller who has
sold the good on credit to fund his receivables till the amount is fully received. So, when the goods
are sold on credit, and the credit period (i.e. the date upto which payment shall be made) is for
example 6 months, factor will pay most of the sold amount up front and rest of the amount later.
Therefore, in this way, a startup can meet his day to day expenses.
3. PITCH PRESENTATION
Pitch presentation is a short and brief presentation (not more than 20 minutes) to investors
explaining about the prospects of the company and why they should invest into the startup
business. So, pitch deck presentation is a brief presentation basically using PowerPoint to provide
a quick overview of business plan and convincing the investors to put some money into the
business. Pitch presentation can be made either during face to face meeting s or online meetings
with potential investors, customers, partners, and co-founders. Here, some of the methods have
been highlighted below as how to approach a pitch presentation:
(i) Introduction: To start with, first step is to give a brief account of yourself i.e. who are you?
What are you doing? But care should be taken to make it short and sweet. Also, use this
opportunity to get your investors interested in your company. One can also talk up the most
interesting facts about one’s business, as well as any huge milestones one may ha ve achieved.
(ii) Team: The next step is to introduce the audience the people behind the scenes. The
reason is that the investors will want to know the people who are going to make the product or
service successful. Moreover, the investors are not only putting money towards the idea but they
are also investing in the team. Also, an attempt should be made to include the background of the
promoter, and how it relates to the new company. Moreover, if possible, it can also be highlighted
that the team has worked together in the past and achieved significant results.
(iii) Problem: Further, the promoter should be able to explain the problem he is going to solve
and solutions emerging from it. Further the investors should be convinced that the newly
introduced product or service will solve the problem convincingly.
For instance, when Facebook was launched in 2004, it added some new features which give it a
more professional and lively look in comparison to Orkut which was there for some time. It enabled
Facebook to become an instant hit among the people. Further, customers have no privacy while
using Orkut. However, in Facebook, you can view a person’s profile only if he adds you to his list.
These simple yet effective advantages that Facebook has over Orkut make it an extremely popular
social networking site.
(iv) Solution: It is very important to describe in the pitch presentation as to how the company is
planning to solve the problem. For instance, when Flipkart first started its business in 2007, it
brought the concept of e-commerce in India but when they started, payment through credit card
was rare. So, they introduced the system of payment on the basis of cash on delivery which was
later followed by other e-commerce companies in India. The second problem was the entire
supply chain system. Delivering goods on time is one of the most important factors that
determine the success of an ecommerce company. Flipkart addressed this issue by launching
their own supply chain management system to deliver orders in a timely manner. These
innovative techniques used by Flipkart enabled them to raise large amount of capital from the
investors.
(v) Marketing/Sales: This is a very important part where investors will be deeply interested.
The market size of the product must be communicated to the investors. This can include profiles of
target customers, but one should be prepared to answer questions about how the promoter is
planning to attract the customers. If a business is already selling goods, the promoter can also
brief the investors about the growth and forecast future revenue.
(vi) Projections or Milestones: It is true that it is difficult to make financial projections for a
startup concern. If an organization doesn’t have a long financial history, an educated guess ca n be
made. Projected financial statements can be prepared which gives an organization a brief idea
about where is the business heading? It tells us that whether the business will be making profit or
loss?
Financial projections include three basic documents that make up a business’s financial
statements.
• Income statement: This projects how much money the business will generate by projecting
income and expenses, such as sales, cost of goods sold, expenses and capital. For your
first year in business, you’ll want to create a monthly income statement. For the second
year, quarterly statements will suffice. For the following years, you’ll just need an annual
income statement.
• Cash flow statement: A projected cash flow statement will depict how much cash will be
coming into the business and out of that cash how much cash will be utilized into the
business. At the end of each period (e.g. monthly, quarterly, annually), one can tally it all
up to show either a profit or loss.
• Balance sheet: The balance sheet shows the business’s overall finances including assets,
liabilities and equity. Typically, one will create an annual balance sheet for one’s financial
projections.
(vii) Competition: Every business organization has competition even if the product or service
offered is new and unique. It is necessary to highlight in the pitch presentation as to how the
products or services are different from their competitors. If any of the competitors have been
acquired, their complete details like name of the organization, acquisition prices etc. should also
be highlighted.
(viii) Business Model: The term business model is a wide term denoting core aspects of a
business including purpose, business process, target customers, offerings, strategies,
infrastructure, organizational structures, sourcing, trading practices, and operational processes
and policies including culture.
Further, as per Investopedia, a business model is the way in which a company generates revenue
and makes a profit from company operations. Analysts use the term gross profit as a way to
compare the efficiency and effectiveness of a firm's business model. Gross profit is calc ulated by
subtracting the cost of goods sold from revenues. A business model can be illustrated with the
help of an example. There are two companies – company A and company B. Both the companies
are engaged in the business of renting movies. Prior to the advent of internet both the companies
rent movies physically. Both the companies made ` 5 crore as revenues. Cost of goods sold was `
4 crore. So, the companies made ` 1 crore as gross profit. After the introduction of internet,
company A started to offer movies online instead of renting or selling it physically. This change
affected the business model of company A positively. Revenue is still ` 5 crore but the significant
part is that cost of goods sold is now ` 2 crore only. This is because online sales lead to significant
reduction of storage and distribution costs. So, the gross profit increases from 20% to 60%.
Therefore, Company A isn't making more in sales, but it figured out a way to r evolutionize its
business model, which greatly reduces costs. Managers at company A have an additional 40%
more in margin to play with than managers at company A. Managers at company A have little room
for error and they have to tread carefully.
Hence, every investor wants to get his money back, so it's important to tell them in a pitch
presentation as to how they should plan on generating revenue. It is better to show the investors a
list of the various revenue streams for a business model and the timeline for each of them. Further,
how to price the product and what does the competitor charge for the same or similar product shall
also be highlighted. It is also beneficial to discuss the lifetime value of the customer and what
should be the strategy to keep him glued to their product.
(ix) Financing: If a startup business firm has raised money, it is preferable to talk about how
much money has already been raised, who invested money into the business and what they did
about it. If no money has been raised till date, an explanation can be made regarding how much
work has been accomplished with the help of minimum funding that the company is managed to
raise.
It is true that investors like to see entrepreneurs who have invested their own money. If a promoter
is pitching to raise capital he should list how much he is looking to raise and how he intend to use
the funds.
4. MODES OF FINANCING FOR STARTUPS

(i) Bootstrapping : An individual is said to be boot strapping when he or she attempts to
found and build a company from personal finances or from the operating revenues of the new
company.
A common mistake made by most founders is that they make unnecessary expenses towards
marketing, offices and equipment they cannot really afford. So, it is true that more money at the
inception of a business leads to complacency and wasteful expenditure. On the other hand,
investment by startups from their own savings leads to cautious approach. It curbs wasteful
expenditures and enable the promoter to be on their toes all the time.
Here are some of the methods in which a startup firm can bootstrap:
(a) Trade Credit: When a person is starting his business, suppliers are reluctant to give trade
credit. They will insist on payment of their goods supplied either by cash or by credit card.
However, a way out in this situation is to prepare a well-crafted financial plan. The next step is to
pay a visit to the supplier’s office. If the business organization is small, the owner can be directly
contacted. On the other hand, if it is a big firm, the Chief Financial Officer can be contacted and
convinced about the financial plan.
Communication skills are important here. The financial plan has to be shown. The owner or the
financial officer has to be explained about the business and the need to get the first order on credit
in order to launch the venture. The owner or financial officer may give half the order on credit and
balance on delivery. The trick here is to get the goods shipped and sell them before paying to
them. One can also borrow to pay for the good sold but there is interest cost also. So trade credit
is one of the most important way to reduce the amount of working capital one needs. This is
especially true in retail operations.
When you visit your supplier to set up your order during your startup period, ask to speak directly
to the owner of the business if it's a small company. If it's a larger business, ask to speak to the
chief financial officer or any other person who approves credit. Introduce yourself. Show the officer
the financial plan that you have prepared. Tell the owner or financial officer about your business,
and explain that you need to get your first orders on credit in order to launch your venture.
The owner or financial officer may give half the order on credit, with the balance due upon delivery.
Of course, the trick here is to get the goods shipped, and sell them before one has to pay for them.
One could borrow money to pay for the inventory, but you have to pay interest on that money. So
trade credit is one of the most important ways to reduce the amount of working capital one needs.
This is especially true in retail operations.
(b) Factoring: This is a financing method where accounts receivable of a business organization
is sold to a commercial finance company to raise capital. The factor then got hold of the accounts
receivable of a business organization and assumes the task of collecting the receivables as well as
doing what would've been the paperwork. Factoring can be performed on a non-notification basis.
It means customers may not be told that their accounts have been sold.
However, there are merits and demerits to factoring. The process of factoring may actually reduce
costs for a business organization. It can actually reduce costs associated with maintaining
accounts receivable such as bookkeeping, collections and credit verifications. If comparison can
be made between these costs and fee payable to the factor, in many cases it has been observed
that it even proved fruitful to utilize this financing method.
In addition to reducing internal costs of a business, factoring also frees up money that would
otherwise be tied to receivables. This is especially true for businesses that sell to other businesses
or to government; there are often long delays in payment that this would offset. This money can be
used to generate profit through other avenues of the company. Factoring can be a very useful tool
for raising money and keeping cash flowing.
(c) Leasing: Another popular method of bootstrapping is to take the equipment on lease rather
than purchasing it. It will reduce the capital cost and also help lessee (person who take the asset
on lease) to claim tax exemption. So, it is better to a take a photocopy machine, an automobile or
a van on lease to avoid paying out lump sum money which is not at all feasible for a startup
organization.
Further, if you are able to shop around and get the best kind of leasing arrangement when you're
starting up a new business, it's much better to lease. It's better, for example, to lease a
photocopier say at ` 5,000 per month , rather than pay ` 1,00,000 for it; or lease your automobile
or van to avoid paying out ` 5,00,000 or more.
There are advantages for both the startup businessman using the property or equipment (i.e.
the lessee) and the owner of that property or equipment (i.e. the lessor.) The lessor enjoys tax
benefits in the form of depreciation on the fixed asset leased and may gain from capital
appreciation on the property, as well as making a profit from the lease. The lessee benefits by
making smaller payments retain the ability to walk away from the equipment at the end of the lease
term. The lessee may also claim tax benefit in the form of lease rentals paid by him.
(ii) Angel Investors: Despite being a country of many cultures and communities traditionally
inclined to business and entrepreneurship, India still ranks low on comparative ratings across
entrepreneurship, innovation and ease of doing business. The reasons are obvious . These include
our old and outdated draconian rules and regulations which provides a hindrance to our business
environment for a long time. Other reasons are red tapism, our time consuming procedures, and
lack of general support for entrepreneurship. Off course, things are changing in recent times.
As per Investopedia, Angel investors invest in small startups or entrepreneurs. Often, angel
investors are among an entrepreneur's family and friends. The capital angel investors provide may
be a one-time investment to help the business propel or an ongoing injection of money to support
and carry the company through its difficult early stages.
Angel investors provide more favorable terms compared to other lenders, since they usually invest
in the entrepreneur starting the business rather than the viability of the business. Angel investors
are focused on helping startups take their first steps, rather than the possible profit they may get
from the business. Essentially, angel investors are the opposite of venture capitalists.
Angel investors are also called informal investors, angel funders, private investors, seed investors
or business angels. These are affluent individuals who inject capital for startups in exchange for
ownership equity or convertible debt. Some angel investors invest through crowdfunding platforms
online or build angel investor networks to pool in capital.
Angel investors typically use their own money, unlike venture capitalists who take care of pooled
money from many other investors and place them in a strategically managed fund.
Though angel investors usually represent individuals, the entity that actually provides the fund may
be a limited liability company, a business, a trust or an investment fund, among many other kinds
of vehicles.
Angel investors who seed startups that fail during their early stages lose their investments
completely. This is why professional angel investors look for opportunities for a defined exit
strategy, acquisitions or initial public offerings (IPOs).
(iii) Venture Capital Fund: Venture Capital Fund means investment vehicle that manage funds
of investors seeking to invest in startup firms and small businesses with exceptional growth
potential. Venture capital is money provided by professionals who alongside managem ent invest in
young, rapidly growing companies that have the potential to develop into significant economic
contributors.
Venture Capitalists generally
• Finance new and rapidly growing companies
• Purchase equity securities
• Assist in the development of new products or services
• Add value to the company through active participation.
Characteristics of Venture Capital Financing

(i) Long time horizon: The fund would invest with a long time horizon in mind. Minimum
period of investment would be 3 years and maximum period can be 10 years.
(ii) Lack of liquidity: When VC invests, it takes into account the liquidity factor. It assumes
that there would be less liquidity on the equity it gets and accordingly it would be investing
in that format. They adjust this liquidity premium against the price and required return.
(iii) High Risk: VC would not hesitate to take risk. It works on principle of high risk and high
return. So, high risk would not eliminate the investment choice for a venture capital.
(iv) Equity Participation: Most of the time, VC would be investing in the form of equity of a
company. This would help the VC participate in the management and help the company
grow. Besides, a lot of board decisions can be supervised by the VC if they participate in
the equity of a company.
Advantages of bringing VC in the company
• It injects long- term equity finance which provides a solid capital base for future growth.
• The venture capitalist is a business partner, sharing both the risks and rewards. Venture
capitalists are rewarded with business success and capital gain.
• The venture capitalist is able to provide practical advice and assistance to the company
based on past experience with other companies which were in similar situations.
• The venture capitalist also has a network of contacts in many areas that can add value to
the company.
• The venture capitalist may be capable of providing additional rounds of funding should it be
required to finance growth.
• Venture capitalists are experienced in the process of preparing a company for an Initial
Public Offering (IPO) of its shares onto the stock exchanges or overseas stock exchange
such as NASDAQ.
• They can also facilitate a trade sale.
Stages of funding for VC
1. Seed Money: Low level financing needed to prove a new idea.
2. Start-up: Early stage firms that need funding for expenses associated with marketing and
product development.
3. First-Round: Early sales and manufacturing funds.
4. Second-Round: Working capital for early stage companies that are selling product, but not
yet turning in a profit.
5. Third Round: Also called Mezzanine financing, this is expansion money for a newly
profitable company.
6. Fourth-Round: Also called bridge financing, it is intended to finance the "going public"
process.
Risk in each stage is different. An indicative Risk matrix is given below:
Financial Period Risk Activity to be financed

Stage (Funds Perception
locked
in years)
Seed 7-10 Extreme For supporting a concept or idea or R&D for product
Money development and involves low level of financing.
Start Up 5-9 Very High Initializing prototypes operations or developing products
and its marketing.
First 3-7 High Started commercials production and marketing.
Stage
Second 3-5 Sufficiently Expanding market and growing working capital need
Stage high though not earning profit.
Third 1-3 Medium Market expansion, acquisition & product development for
Stage profit making company. Also called Mezzanine
Financing.
Fourth 1-3 Low Facilitating public issue i.e. going public. Also called
Stage Bridge Financing.
VC Investment Process
The entire VC Investment process can be segregated into the following steps:
1. Deal Origination: VC operates directly or through intermediaries. Mainly many practicing
Chartered Accountants would work as intermediary and through them VC gets the deal.
Before sourcing the deal, the VC would inform the intermediary or its employees about the
following so that the sourcing entity does not waste time :
• Sector focus
• Stages of business focus
• Promoter focus
• Turn over focus
Here the company would give a detailed business plan which consists of business model,
financial plan and exit plan. All these aspects are covered in a document which is called
Investment Memorandum (IM). A tentative valuation is also carried ou t in the IM.
2. Screening: Once the deal is sourced the same would be sent for screening by the VC. The
screening is generally carried out by a committee consisting of senior level people of the
VC. Once the screening happens, it would select the company for further processing.
3. Due Diligence: The screening decision would take place based on the information provided
by the company. Once the decision is taken to proceed further, the VC would now carry out
due diligence. This is mainly the process by which the VC would try to verify the veracity of
the documents taken. This is generally handled by external bodies, mainly renowned
consultants. The fees of due diligence are generally paid by the VC. However, in many
cases, this can be shared between the investor (VC) and Investee (the company)
depending on the veracity of the document agreement.
4. Deal Structuring: Once the case passes through the due diligence it would now go through
the deal structuring. The deal is structured in such a way that both parties win. In many
cases, the convertible structure is brought in to ensure that the promoter retains the right to
buy back the share. Besides, in many structures to facilitate the exit, the VC may put a
condition that promoter has also to sell part of its stake along with the VC. Such a clause is
called tag- along clause.
5. Post Investment Activity: In this section, the VC nominates its nominee in the board of the
company. The company has to adhere to certain guidelines like strong MIS, strong
budgeting system, strong corporate governance and other covenants of the VC and
periodically keep the VC updated about certain mile-stones. If milestone has not been met
the company has to give explanation to the VC. Besides, VC would also ensure that
professional management is set up in the company.
6. Exit plan: At the time of investing, the VC would ask the promoter or company to spell out
in detail the exit plan. Mainly, exit happens in two ways:
(a) One way is ‘sell to third party(ies)’. This sale can be in the form of IPO or Private
Placement to other VCs.
(b) The second way to exit is that promoter would give a buy back commitment at a pre
agreed rate (generally between IRR of 18% to 25%). In case the exit is not happening in the
form of IPO or third party sell, the promoter would buy back. In many deals, the promoter
buyback is the first refusal method adopted i.e. the promoter would get the first right of
buyback.
Venture Capital Funds in India

Evolution: Venture Capital in India stated in the decade of 1970, when the Government of India
appointed a committee to tackle the issue of inadequate funding to entrepreneurs and start-ups.
However, it is only after ten years that the first all India venture capital funding was started by
IDBI, ICICI and IFCI.
With the institutionalization of the industry in November 1988, the government announced its
guidelines in the “CCI” (Controller of Capital Issues). These focused on a very narrow description
of Venture Capital and proved to be extremely restrictive and encumbering, requiring investment in
innovative technologies started by first generation entrepreneur. This made investment in VC
highly risky and unattractive.
At about the same time, the World Bank organized a VC awareness seminar, giving birth to
players like: TDICICI, GVFL, Canbank and Pathfinder. Along with the other reforms the
government decided to liberalize the VC Industry and abolish the “CCI”, while in 1995 Foreign
Finance companies were allowed to invest in the country.
Nevertheless, the liberalization was short-spanned, with new calls for regulation being made in
1996. The new guidelines’ loopholes created an unequal playing ground that favoured the foreign
players and gave no incentives to domestic high net worth individuals to invest in this industry.
VC investing got considerably boosted by the IT revolution in 1997, as the venture capitalists
became prominent founders of the growing IT and telecom industry.
Many of these investors later floundered during the dotcom bust and most of the surviving ones
shifted their attention to later stage financing, leaving the risky seed and start-up financing to a few
daring funds.
Formation of venture capital has been depicted in the diagram below:
Investors in venture capital funds are shown in the following diagram:
Structure of Venture Capital Fund in India

Structure of fund in India : Three main types of fund structure exist: one for domestic funds and
two for offshore ones:
(a) Domestic Funds : Domestic Funds (i.e. one which raises funds domestically) are usually
structured as:
i) a domestic vehicle for the pooling of funds from the investor, and
ii) a separate investment adviser that carries those duties of asset manager.
The choice of entity for the pooling vehicle falls between a trust and a company, (India, unlike
most developed countries does not recognize a limited partnership), with the trust form prevailing
due to its operational flexibility.
(b) Offshore Funds : Two common alternatives available to offshore investors are: the “offshore
structure” and the “unified structure”.
Offshore structure
Under this structure, an investment vehicle (an LLC or an LP organized in a jurisdiction outside
India) makes investments directly into Indian portfolio companies. Typically, the assets are
managed by an offshore manager, while the investment advisor in India carries out the due
diligence and identifies deals.
Unified Structure
When domestic investors are expected to participate in the fund, a unified structure is used.
Overseas investors pool their assets in an offshore vehicle that invests in a locally managed trust,
whereas domestic investors directly contribute to the trust. This is later device used to make the
local portfolio investments.
Venture capital means funds made available for startup firms and small businesses with
exceptional growth potential. Venture capital is money provided by professionals who alongside
management invest in young, rapidly growing companies that have the potential to develop into
significant economic contributors.
5. STARTUP INDIA INITIATIVE

Startup India scheme was initiated by the Government of India on 16th of January, 2016. As per
GSR Notification 127 (E) dated 19 th February 2019, an entity shall be considered as a Startup:
i. Upto a period of ten years from the date of incorporation/ registration, if it is incorporated as
a private limited company (as defined in the Companies Act, 2013) or registered as a
partnership firm (registered under section 59 of the Partnership Act, 1932) or a limited
liability partnership (under the Limited Liability Partnership Act, 2008) in India.
ii. Turnover of the entity for any of the financial years since incorporation/ registration has not
exceeded one hundred crore rupees.
iii. Entity is working towards innovation, development or improvement of products or processes
or services, or if it is a scalable business model with a high potential of employment
generation or wealth creation.
Provided that an entity formed by splitting up or reconstruction of an existing business shall not be
considered a ‘Startup’.
What is a Startup to avail government schemes?
Up to 10 years from its date of incorporation / registration
Incorporated as either a Private Limited Company or a Registered Partnership Firm or a Limited

Liability Partnership in India
Turnover for any fiscal year has not exceeded INR 100 crore
Entity should not have been formed by splitting up or reconstruction a business already in
existence
Working towards innovation, development, deployment or commercialization of new product,

processes or services driven by technology or intellectual property
Source: http://www.startupindia.gov.in/
TEST YOUR KNOWLEDGE

1. Explain some of the innovative sources for funding a start-up.
2. What do you mean by Pitch Presentation in context of Start-up Business?
ANSWERS/ SOLUTIONS

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Final Course

(Revised Scheme of Education and Training)

© The Institute of Chartered Accountants of India

Edition : November, 2020

Committee/ : Board of Studies

Price (All Modules) : `

Published by : The Publication Department on behalf of The Institute of Chartered

(i) Chapter 4 – Security Valuation

(ii) Chapter 5 – Portfolio Management

(iii) Chapter 12 – Corporate Valuation

Happy Reading and Best Wishes!

PAPER 2: STRATEGIC FINANCIAL MANAGEMENT

(1) Financial Policy and Corporate Strategy

(i) Strategic decision making framework

(ii) Interface of Financial Policy and strategic management

(iii) Balancing financial goals vis-à-vis sustainable growth.

(2) Risk Management

(i) Identification of types of Risk faced by an organisation

(ii) Evaluation of Financial Risks

(iii) Value at Risk (VAR)

(3) Security Analysis

(i) Fundamental Analysis

(ii) Technical Analysis

c) Theories and Principles

e) Efficient Market Hypothesis (EMH) Analysis

(4) Security Valuation

(i) Theory of Valuation

(ii) Return Concepts

(iii) Equity Risk Premium

(iv) Required Return on Equity

(v) Discount Rate Selection in Relation to Cash Flows

(vi) Approaches to Valuation of Equity Shares

(vii) Valuation of Preference Shares

(viii) Valuation of Debentures/ Bonds

(5) Portfolio Management

(i) Portfolio Analysis

(ii) Portfolio Selection

(iii) Capital Market Theory

(iv) Portfolio Revision

(v) Portfolio Evaluation

(vi) Asset Allocation

(vii) Fixed Income Portfolio

(viii) Risk Analysis of Investment in Distressed Securities

(ix) Alternative Investment Strategies in context of Portfolio Management

(ii) Concept and Definition

(iii) Benefits of Securitization

(iv) Participants in Securitization

(v) Mechanism of Securitization

(vi) Problems in Securitization

(vii) Securitization Instruments

(viii) Pricing of Securitization Instruments

(ix) Securitization in India

(7) Mutual Fund

(iv) Advantages and Disadvantages of Mutual Funds

(8) Derivatives Analysis and Valuation

(i) Forward/ Future Contract

(iv) Commodity Derivatives

(9) Foreign Exchange Exposure and Risk Management

(i) Exchange rate determination